Disqualifying Disposition

What it means

When you get Incentive Stock Options (ISOs), the tax rules require you to hold the shares for a certain amount of time to get special tax breaks. You must hold them for at least two years after you were granted the options and one year after you bought the shares.

If you sell the shares before these deadlines, the IRS calls it a disqualifying disposition. This means you lose the special tax treatment for that sale. Instead of paying lower tax rates on all your profit, some of your profit is taxed as regular income, similar to your normal paycheck salary.

A simple example

Imagine Sarah is granted ISOs. She buys the shares for $1,000 (her strike price) when they are worth $5,000. The $4,000 difference is called the spread. If she sells the shares a few months later for $6,000, she has a total gain of $5,000. Because she sold too early, the IRS looks at the smaller amount between her $4,000 spread and her $5,000 total gain. Sarah must count that $4,000 as regular income on her taxes.

Why it matters to you

• You will likely pay more in taxes because part of your profit is taxed as regular income rather than a lower long-term capital gain rate.
• Your employer generally does not take taxes out of this money for you, so you may need to plan ahead to cover the tax bill.
• If you sell the shares in the same year you buy them, you might avoid extra taxes from the Alternative Minimum Tax (AMT), which is a separate tax system for high earners.
• A tax professional can help you understand your specific situation.

Common mistakes to avoid

• Selling your shares in a panic because the price moved, without checking if you have met the one-year or two-year holding requirements.
• Forgetting to report this income on your tax return, which can lead to penalties from the IRS.

Words used on this page

• Incentive Stock Option (ISO): A special type of stock option that can offer tax benefits if you follow strict holding rules.
• Spread: The difference between the price you paid for your stock and the actual value of the stock at that time.
• Ordinary Income: Money you earn, like your salary, that is taxed at your standard income tax rate.
• Capital Gain: The profit you make when you sell an asset for more than you paid for it.
• Alternative Minimum Tax (AMT): A separate set of tax rules designed to make sure people with certain types of income or deductions still pay some tax.