What Is a Qualifying Disposition for Tax Purposes?

Many companies offer stock to their employees as compensation through plans like Incentive Stock Options (ISOs) and Employee Stock Purchase Plans (ESPPs). When an employee later sells this stock, the transaction is known as a disposition. The tax implications of this sale depend heavily on how long the shares are held before being sold, which determines how the transaction is taxed by the Internal Revenue Service.

Defining a Qualifying Disposition

A qualifying disposition is a term for the sale of stock acquired through an Incentive Stock Option (ISO) or an Employee Stock Purchase Plan (ESPP). For a sale to be considered qualifying, it must satisfy two holding period requirements set by the Internal Revenue Code, which results in more favorable tax treatment.

The first requirement is that the stock must be sold more than two years after the option was granted. The grant date is when the company offers the employee the right to buy stock; for an ESPP, this is the offering date. The second requirement is that the stock must be sold more than one year after it was purchased, known as the exercise date. Failing to meet both of these timeframes results in a disqualifying disposition, which has less favorable tax consequences.

For example, an ISO was granted on June 1, 2022, and the employee purchased the shares on July 1, 2023. To meet the two-year rule, the sale must occur after June 1, 2024. To meet the one-year rule, the sale must occur after July 1, 2024. Therefore, to achieve a qualifying disposition, the employee must wait to sell the shares until at least July 2, 2024.

Tax Implications of a Qualifying Disposition

The primary advantage of a qualifying disposition is that the profit is treated as a long-term capital gain, which is generally taxed at a lower rate than ordinary income. The gain is calculated by taking the final sale price per share, subtracting the original exercise price per share, and multiplying that amount by the number of shares sold. For example, if an employee exercises 1,000 ISO shares at $10 per share and later sells them in a qualifying disposition for $30 per share, the long-term capital gain would be $20,000.

A consideration for ISOs involves the Alternative Minimum Tax (AMT). While no regular tax is due when you exercise an ISO, the “bargain element” can trigger the AMT. The bargain element is the difference between the fair market value of the stock on the exercise date and the price the employee paid for it. This amount is considered an adjustment item for the AMT in the year of exercise, which can lead to a tax liability even before any shares are sold. When the shares are later sold in a qualifying disposition, it can affect the AMT calculation again by generating an AMT credit, which can be used to offset regular tax liability in future years.

ESPPs have a specific tax treatment. In a qualifying disposition of ESPP shares, a portion of the gain may be taxed as ordinary income. This portion is equal to the discount the employee received on the purchase price. Any remaining gain beyond that discount is then treated as a long-term capital gain. For instance, if the stock had a market value of $10 on the offering date and the employee bought it for $8.50, that $1.50 discount per share would be taxed as ordinary income when sold, with the rest of the profit taxed as a capital gain.

Information Required for Tax Reporting

To properly report the sale of stock from an employee plan, specific documents are needed to calculate gains and verify holding periods. After an employee exercises an ISO, the employer is required to provide Form 3921, “Exercise of an Incentive Stock Option.” This form contains the critical dates and values needed, including:

• The grant date
• The exercise date
• The exercise price per share
• The fair market value per share on the date of exercise

Similarly, for shares purchased through an ESPP, the employer provides Form 3922, “Transfer of Stock Acquired Through an Employee Stock Purchase Plan.” This document details:

• The offering date
• The purchase date
• The purchase price per share
• The fair market value of the stock on both the offering and purchase dates

When the shares are eventually sold, the brokerage firm that handled the transaction will issue Form 1099-B, “Proceeds from Broker and Barter Exchange Transactions.” A common issue is that the cost basis reported on Form 1099-B is often incorrect for shares from employee stock plans. The broker may report the basis as zero or simply as the exercise price, without accounting for any compensation element that should adjust the basis. Because of this potential discrepancy, it is the taxpayer’s responsibility to use the information from Form 3921 or Form 3922 to calculate the correct cost basis. Relying solely on the Form 1099-B can lead to an overpayment of taxes.

How to Report the Sale on Your Tax Return

Once you have the necessary forms and have calculated the correct cost basis, the sale must be reported 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 in column (d) and your correctly calculated cost basis in column (e).

If the cost basis on your Form 1099-B was incorrect and you are reporting the correct basis, you will need to make an adjustment. The IRS provides specific codes for this purpose. You would enter code “B” in column (f) of Form 8949 to indicate that the basis reported by the broker was incorrect, and in column (g), you would enter the amount of the adjustment.

After completing Form 8949 for all capital asset sales, the totals are transferred to Schedule D, “Capital Gains and Losses.” Schedule D summarizes the short-term and long-term gains and losses from Form 8949 to calculate the final net capital gain or loss for the year, which is then carried over to your main tax return, Form 1040.

For those who had an AMT adjustment when they exercised their ISOs, the subsequent sale of that stock will involve Form 6251, “Alternative Minimum Tax—Individuals.” Reporting the sale of the stock can result in an AMT credit, which is calculated on Form 8801, “Credit for Prior Year Minimum Tax.”