What Is a Qualifying Disposition for Tax Purposes?

A qualifying disposition is a sale of stock from an employee benefit plan that meets specific criteria, allowing gains to be taxed at lower long-term capital gains rates instead of higher ordinary income rates. This term is most relevant for shares obtained through an Incentive Stock Option (ISO) plan or an Employee Stock Purchase Plan (ESPP). A sale that does not meet these criteria is a disqualifying disposition and results in less favorable tax treatment.

Holding Period Requirements for a Qualifying Disposition

To achieve a qualifying disposition, the sale of your stock must satisfy two holding period requirements.

First, you must sell the stock more than two years after the grant date. The grant date is when the company grants you the option to buy stock under an ISO plan or the first day of the offering period for an ESPP.

Second, you must hold the stock for more than one year after the exercise date. The exercise date, also known as the purchase date, is the day you actually buy the shares, either by acting on your option for an ISO or when the company buys shares on your behalf for an ESPP.

Both rules must be satisfied. For example, if your option was granted on January 1, 2023, and you exercised it on February 1, 2024, you must wait to sell until after February 1, 2025. A sale on this date meets both conditions, as it is more than two years after the grant and one year after the exercise.

Tax Treatment of a Qualifying Disposition

The tax treatment for a qualifying disposition depends on whether the shares came from an ISO or an ESPP.

For shares from an Incentive Stock Option (ISO) plan, the entire difference between your final sale price and your purchase price is taxed as a long-term capital gain. For instance, if you purchased ISO shares at $10 and sold them for $50, your $40 gain per share is a long-term capital gain.

The Alternative Minimum Tax (AMT) is a consideration for ISOs. When you exercise ISOs, the bargain element—the difference between the stock’s fair market value at exercise and your purchase price—is an adjustment item for the AMT. This can trigger an AMT liability in the year of exercise. A subsequent qualifying disposition can generate an AMT credit, which may help you recover some of the AMT paid.

For shares from an Employee Stock Purchase Plan (ESPP), part of your gain is taxed as ordinary income, and the rest is a long-term capital gain. The portion taxed as ordinary income is the lesser of either the original discount offered on the grant date or your total gain from the sale. Any remaining profit is taxed as a long-term capital gain.

Tax Consequences of a Disqualifying Disposition

In a disqualifying disposition, the profit from the sale is split into two components that are taxed differently.

The first component is the bargain element, which is taxed as ordinary income and calculated as the difference between the stock’s fair market value on the exercise date and the price you paid. This amount is considered compensation income, similar to a bonus, and is taxed at your marginal income tax rate. Your employer typically reports this amount on your Form W-2.

Any remaining profit or loss is a capital gain or loss, calculated by subtracting the exercise date’s market value from the final sale price. This gain is short-term if you held the stock for one year or less after exercise, or long-term if held for more than one year.

For example, assume you exercised an option to buy stock at $10 when its market value was $30, and you sold it a few months later for $45. The $20 bargain element ($30 – $10) is taxed as ordinary income. The remaining $15 of profit ($45 – $30) is a short-term capital gain, also taxed at ordinary income rates.

How to Report the Sale on Your Tax Return

To report the sale, you will use several documents. Your employer provides Form 3921 for ISOs or Form 3922 for ESPPs, which detail the grant date, exercise price, and market value on the exercise date. Your brokerage firm provides Form 1099-B, which details the sale proceeds.

A common issue is an incorrect cost basis on Form 1099-B. The broker may only report your purchase price, failing to account for the portion of your gain treated as ordinary income. This can lead to overpaying taxes if not adjusted.

The sale is reported on Form 8949, Sales and Other Dispositions of Capital Assets, where you will enter the details from your Form 1099-B. You must then adjust the cost basis reported by the broker to reflect the correct amount. For a disqualifying disposition, you increase the basis by the amount of compensation income reported on your W-2, and this same adjustment is necessary for the ordinary income portion of a qualifying ESPP disposition.

After completing Form 8949, the totals are carried to Schedule D, Capital Gains and Losses. The ordinary income portion of your gain is also reported on your tax return, typically as ‘Other Income’ on Schedule 1 of Form 1040.