Notice of disqualifying disposition of ISO shares: Overview, definition, and example
What is a notice of disqualifying disposition of ISO shares?
A notice of disqualifying disposition of ISO (Incentive Stock Option) shares is a formal notification that an individual must provide to their employer or the relevant tax authority when they sell or dispose of shares acquired through an ISO in a way that does not meet the necessary requirements for favorable tax treatment. Typically, for an ISO to qualify for tax benefits (such as deferring tax liability until the shares are sold), the shares must be held for a minimum period after exercise—at least one year after the exercise date and two years after the grant date. If the shares are sold before meeting these holding periods, it is considered a disqualifying disposition, and the individual must notify the appropriate parties.
Why is a notice of disqualifying disposition of ISO shares important?
This notice is important because the IRS requires individuals to report any disqualifying dispositions of ISO shares to ensure that the correct tax treatment is applied. In the case of a disqualifying disposition, the favorable tax treatment for ISOs (which allows gains to be taxed as long-term capital gains) is lost. Instead, the individual will have to pay ordinary income tax on the difference between the exercise price and the fair market value at the time of sale. By filing a notice of disqualifying disposition, the individual ensures compliance with tax regulations and helps to avoid potential penalties or misreporting of income.
Understanding notice of disqualifying disposition of ISO shares through an example
For example, an employee exercises 1,000 ISO shares at an exercise price of $10 per share, and the current market value of the shares is $20. The employee holds the shares for only 6 months before selling them, making it a disqualifying disposition because the shares were not held for the required one-year period from the exercise date. The employee must then submit a notice of disqualifying disposition to the employer or tax authority, notifying them of the early sale. The employee will be taxed on the difference between the exercise price ($10) and the fair market value at the time of sale ($20) as ordinary income, rather than at the long-term capital gains rate.
In another example, an employee exercises ISO options and holds the shares for 18 months before selling them. Since the required holding period for an ISO is one year after exercise, this would be a qualifying disposition, meaning no notice of disqualifying disposition is required. However, if the employee had sold the shares before meeting the holding period, they would need to provide notice of disqualifying disposition and pay ordinary income taxes accordingly.
An example of a notice of disqualifying disposition of ISO shares clause
Here’s how a clause regarding a notice of disqualifying disposition might appear in a stock option agreement:
“If the Optionee disposes of any shares acquired upon the exercise of an Incentive Stock Option (ISO) within one year from the exercise date or within two years from the grant date, the Optionee must promptly notify the Company of the disqualifying disposition. The Company will then report the disqualifying disposition to the IRS as required by tax law.”
Conclusion
A notice of disqualifying disposition of ISO shares is a critical requirement for individuals who sell ISO-acquired shares before meeting the necessary holding periods. It ensures compliance with IRS regulations and helps individuals report income correctly. Without this notice, there could be tax penalties or incorrect tax reporting, leading to potential issues with the tax authorities. Understanding when a disposition qualifies or disqualifies for favorable tax treatment is essential for anyone holding or exercising ISOs.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.