However, if your short-term goal is to reduce single-stock concentration, a disqualifying disposition
strategy may outweigh the tax benefits of holding the underlying stock.
A disqualifying disposition
occurs when the shares are held less than two years after the beginning of the offering period.
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.
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.
A disqualifying disposition
occurs when an employee sells ISO shares without satisfying the holding period requirement.
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
Before discussing these techniques, however, it should be noted that some of the most popular measures for facilitating the exercise of options by employees with limited funds -- for example, so-called cashless exercise programs, often involving the financing of the exercise price through a broker and an immediate sale of the shares so purchased to the extent necessary to pay the loan -- do not work well in the ISO context because of the disqualifying disposition
Postpone exercising or triggering a disqualifying disposition
of incentive stock options (ISOs): Under Sec.
For stock options the IRS may look at whether there has been proper income inclusion on option exercise (of on a disqualifying disposition
of stock acquired from such exercise), participation rights in employee stock purchase plans and general statutory compliance.