When an employee disposes of ISOs within two years of the grant date or within one year of the exercise date, however, the company receives a tax deduction equal to the difference between the options' original fair value and the exercise price on the date that the
disqualifying disposition has taken place.
If the ISO stock is disposed of before the holding period is met, it is a "
disqualifying disposition" (Sec.
If you sell the stock upon exercise or within 12 months (a "
disqualifying disposition"), the ISOs' profit would be taxed as ordinary income.
A
disqualifying disposition occurs when the shares are held less than two years after the beginning of the offering period.
Under the new law, gains resulting from the exercise of an incentive stock option or an employee stock purchase plan (ESPP) option, or a
disqualifying disposition of such stock, will not be treated as employment tax wages.
But just 71 percent of companies granting ISOs track
disqualifying disposition, meaning that many companies are losing potentially significant tax deductions.
The first the public heard of this distinction was in Private Letter Ruling 9243026 (June 24, 1992), in which the IRS concluded that FICA and FUTA taxes applied at the time of the ESPP option exercise to the difference between the fair market value of the stock and the exercise price and, further, that federal income tax withholding applied to the income on
disqualifying disposition.
If an option otherwise qualifies as an ISO, but the optionee disposes of acquired shares prior to expiration of both statutory holding periods (two years after grant and one year after exercise), the optionee is taxed, at the time of the
disqualifying disposition, as if the option were nonstatutory.
If, on the other hand, the employee sells the stock before the statutory holding period ends, the sale will be a
disqualifying disposition, and the employee will recognize ordinary income, which is taxed at a higher rate.
422(c)(2) limits the compensation income the employee must include as a result of the
disqualifying disposition, to the excess (if any) of the amount realized on the disposition over the stock's adjusted basis.
When a
disqualifying disposition of an ISO occurs when an employee disposes of the stock within two years of the option grant date or within one year of the option exercise date--the company gets a tax deduction equal to the difference between the option's fair value and the exercise price on the date the
disqualifying disposition took place.