How Is a Disqualifying Disposition of an ISO Taxed?

An Incentive Stock Option (ISO) is a form of employee compensation allowing the purchase of company stock at a set price, offering potential tax advantages. The tax outcome for selling ISO shares depends on the timing of the sale. This article explains the tax consequences of a “disqualifying disposition.”

Understanding ISO Holding Periods

To receive the most favorable tax treatment for shares acquired through an ISO, two holding period requirements must be satisfied. The first rule is that the stock must be sold more than two years after the date the option was granted. The second rule requires that the stock be sold more than one year after the employee exercised the option and purchased the shares. Satisfying both of these conditions results in a “qualifying disposition,” where the profit is taxed at lower long-term capital gains rates.

A “disqualifying disposition” occurs if either one or both of these holding period rules are not met. For example, if an employee is granted options on January 1, 2023, exercises them on June 1, 2024, and sells the shares on December 1, 2024, the sale is a disqualifying disposition. The sale date is not more than one year from the exercise date, failing the second rule.

Tax Calculation for a Disqualifying Disposition

When a disqualifying disposition occurs, the profit from the sale is often split into two components for tax purposes: ordinary income and capital gain. The amount treated as ordinary income is taxed at the employee’s standard marginal income tax rate. This amount is defined as the lesser of two figures: the bargain element at exercise or the actual gain on the sale.

The bargain element is the difference between the Fair Market Value (FMV) of the stock on the day the option was exercised and the exercise price paid for the shares. The actual gain is the difference between the final sale price of the stock and the exercise price. For instance, if the exercise price was $10, the FMV on the exercise date was $30 (a $20 bargain element), and the stock was sold for $50 (a $40 actual gain), the ordinary income would be limited to the $20 bargain element.

Any remaining profit above the amount treated as ordinary income is classified as a capital gain. The nature of this capital gain, whether short-term or long-term, depends on how long the shares were held from the exercise date to the sale date. If the shares were held for one year or less, the capital gain is short-term and taxed at ordinary income rates. If held for more than one year, it is a long-term capital gain, which is taxed at more favorable rates.

As another example, an employee exercises options at $10 when the FMV is $25 and later sells the shares for $40. The bargain element is $15, and the total gain is $30. The ordinary income is $15 (the lesser amount), and the remaining $15 is capital gain. If this sale occurred six months after exercise, the $15 gain would be short-term capital gain.

It is also possible for the entire gain to be treated as ordinary income if the stock is sold for a price that is less than the FMV on the exercise date but still above the exercise price. In a scenario where the stock is sold for less than the original exercise price, the employee recognizes no ordinary income and instead has a capital loss equal to the difference between the exercise price and the sale price.

Reporting a Disqualifying Disposition on Your Tax Return

Properly reporting a disqualifying disposition requires careful attention to several tax forms to ensure the income is correctly classified. Your employer is responsible for reporting the ordinary income portion of the gain as wages in Box 1 of your Form W-2. You should also look for Code V in Box 12, which reports the income from the exercise of nonstatutory stock options, as ISOs in a disqualifying disposition are taxed similarly.

You will also receive Form 3921, Exercise of an Incentive Stock Option Under Section 422, from your employer. This informational form provides the data needed for your tax calculations, detailing the grant date, exercise date, exercise price per share, and the fair market value per share on the exercise date.

The third document is Form 1099-B, Proceeds From Broker and Barter Exchange Transactions, which you will receive from your brokerage firm. This form reports the gross proceeds from the sale of your shares. The cost basis reported in Box 1e of Form 1099-B is commonly incorrect for a disqualifying disposition. Brokers may only report the original exercise price paid for the shares, not the adjusted basis that includes the compensation income.

The primary action for filing is to report the sale on Form 8949, Sales and Other Dispositions of Capital Assets. On this form, you will enter the sale proceeds as reported on your Form 1099-B. You must then adjust the cost basis to prevent being taxed twice on the ordinary income portion. The correct cost basis is the original exercise price plus the amount of compensation income that was already included in your W-2 wages.

This adjusted basis is entered in column (g) of Form 8949, and you will use code “B” in column (f) to indicate that the basis reported on Form 1099-B was incorrect. The difference between your sale proceeds and this corrected cost basis will be your capital gain or loss. The totals from Form 8949 are then transferred to Schedule D, Capital Gains and Losses, which is filed with your Form 1040.