Qualifying Disposition
Candlefocus EditorAn employee stock purchase plan (ESPP) is typically used by companies to incentivize their employees to stay and perform well at their job. ESPPs allow employees with three years of service to purchase company stock at reduced rates. When the stock is sold, or a disposition occurs, the stock can typically qualify for favorable tax treatment.
Incentive stock options (ISOs) are employee stock options offered by companies to their employees in exchange for services. The stock option is a contract that gives the employee the right to purchase shares of the company at a predetermined, discounted price at some point in the future. When the stock option is exercised and the employee sells the underlying shares, the difference between the market value and the exercise price, is taxable income or “capital gain” for the employee. If the disposition of the stock option is considered a qualifying one, then the gain becomes taxed at the lower capital gains rate.
In contrast, non-statutory stock options (NSOs) do not qualify for capital gains tax treatment and any gain on the sale of stock acquired through this type of option is taxed as ordinary income.
Unlike ESPPs and ISOs, a dispositions that do not meet the criteria of a qualifying disosition are subject to unfavorable taxation; the realized gain is taxed at the taxpayer's ordinary income rate.
It is important to note that when filing taxes, a taxpayer must specify which type of disposition theyre claiming and provide supporting documentation. The IRS requires taxpayers to provide proof of timing, records of any tax withholdings, and other associated paperwork to ensure the disposition qualifies for favorable tax treatment.
In summary, a qualifying disposition is an IRS-sanctioned transaction that results in tax benefits for the taxpayer when stock is purchased through an employee stock purchase plan (ESPP) or acquired through an incentive stock option (ISO). Non-statutory stock options (NSOs) do not qualify for capital gains tax treatment and any gain on the sale of stock is taxed as ordinary income. It is important for taxpayers to provide the necessary documentation to ensure their disposition is considered a qualifying one and their gain is taxed at the lower capital gains rate.