# What Is a Qualifying Disposition and How Does It Work?

## What Is a Qualifying Disposition?

Qualifying disposition refers to a sale, transfer, or exchange of stock that qualifies for favorable tax treatment. Individuals typically acquire this type of stock through an incentive stock option (ISO), or through a qualified [employee stock purchase plan (ESPP)](https://www.investopedia.com/terms/e/espp.asp). A qualified ESPP requires shareholder approval before it is implemented. Furthermore, all plan members must have equal rights in the plan.

### Key Takeaways

*   A qualifying disposition is the sale or transfer of stock that qualifies for favorable tax treatment.
*   Shares involved in qualifying dispositions are traditionally acquired through an employee stock purchase plan (ESPP), or through an incentive stock option (ISO). 
*   Non-statutory stock options (NSOs) do not qualify for capital gains tax treatment and get taxed at ordinary income rates.﻿﻿
*   ESPPs and ISOs are used by companies to attract and retain talented personnel.

## How Qualifying Disposition Works

To be a qualifying disposition, the employee must sell their position at least one year after exercising the stock, and two years after the [incentive stock option (ISO)](https://www.investopedia.com/terms/i/iso.asp) was granted, or two years after the beginning of the ESPP offering period.﻿﻿

For example, suppose Cathy’s ISO options were granted September 20, 2018, and she exercises them September 20, 2019. In this scenario, Cathy must wait until September 20, 2020, before she may report a long-term capital gain.

The capital gains treatment for a qualifying disposition applies to the amount of the sale represented by the difference between the exercise price of the option's stock, and the market price at which the stock sold. For example, if Tim exercises 1,000 ISO options at $10 per share, and sells them for $30 per share, he consequently will report a capital gain of $20,000 ($20 x 1000 shares).﻿﻿

Non-statutory stock options (NSOs) do not qualify for capital gains tax treatment and are taxed at ordinary income rates.﻿﻿ Issuing a compensation package that includes ISOs and a qualified ESPP helps companies attract and retain top-tier personnel. It also aligns a company’s management and key employees with its shareholders, as they all want the company to succeed and increase its share price.

Some companies do not offer ISOs, because contrary to non-statutory (or non-qualified) option plans there is no tax deduction for the company when the options are exercised.﻿﻿

## Special Considerations 

“Bargain element” refers to an option that can be exercised below the current market price, which provides the employee with an immediate profit. An employee who exercises a non-statutory option must report the bargain element as earned income, which is subject to income tax. It should be noted that employees who hold ISOs are not mandated to report the bargain element, until after they sell their shares.﻿﻿

The bargain element is reported as ordinary income if the shares were immediately sold after they were exercised (a disqualifying disposition). By contrast, the bargain element is reported as a long-term capital gain if the sale was executed one year after exercising the options, and two years after the grant date (qualifying disposition).﻿﻿

> **Important**
>
> The bargain element for NSOs is added to an individual’s alternative minimum taxable income, which has a flat tax meant to ensure everyone pays their fair share of taxes despite tax minimization strategies.﻿﻿ 

## Qualifying Distribution vs. Disqualifying Distribution 

A disqualifying distribution is the sale or exchange of shares received from an ISO or ESPP before the holding period has been met. The ISO holding period is one year from the exercise date and two years from the grant date or two years from the ESPP offering date. Gains or losses realized in a disqualifying disposition are taxed at a higher rate.﻿﻿

If ESPP or ISO shares are sold in a qualifying disposition, the bargain amount is taxed at the capital gains rate. Disqualifying dispositions are recorded at the [income tax](https://www.investopedia.com/terms/i/incometax.asp) rate, which is generally higher than the capital gains tax.﻿﻿

> **Article Sources**
>
> 1.  U.S. Office of the Law Revision Counsel. "[26 USC 423: Employee Stock Purchase Plans](https://uscode.house.gov/view.xhtml?req=granuleid:USC-prelim-title26-section423&num=0&edition=prelim)." Accessed Feb. 28, 2021.
>     
> 2.  Internal Revenue Service. "[Topic No. 427 Stock Options](https://www.irs.gov/taxtopics/tc427)." Accessed Feb. 28, 2021.
>     
> 3.  Internal Revenue Service. "[Publication 525 (2020), Taxable and Nontaxable Income](https://www.irs.gov/publications/p525#en_US_2020_publink1000229199)." Accessed Feb. 28, 2021.
>     
> 4.  Internal Revenue Service. "[Equity (Stock) - Based Compensation Audit Techniques Guide (August 2015)](https://www.irs.gov/businesses/corporations/equity-stock-based-compensation-audit-techniques-guide)." Accessed Feb. 28, 2021.