TLDR
A Disqualifying Disposition refers to the sale of ISOs shares within the same tax year as exercise, allowing you to pay ordinary income tax instead of AMT.
What is an ISO Disqualifying Disposition?
Incentive Stock Options (ISOs) offer unique tax benefits to employees of qualifying companies. However, if certain conditions are not met, the sale of these stocks can lead to what is known as a disqualifying disposition. This term describes the sale or transfer of ISO shares within the same calendar year as their exercise, which triggers short-term capital gains tax on the profits. Additionally, disqualifying dispositions for ISOs forfeit their favorable tax treatment under the Alternative Minimum Tax (AMT). Consequently, you will lose the benefit of the lower AMT rate on your exercise cost and sacrifice any chance at Long-Term Capital Gains. However, you will also have achieved liquidity from your potentially risky private stock. Essentially you are trading preferential tax treatment for liquidity.
Why Does a Disqualifying Disposition Matter?
A disqualifying disposition can have significant tax implications for employees. When an ISO is sold before the mandatory holding period, the gain on the sale is treated as ordinary income rather than capital gains, which is generally taxed at a lower rate. Luckily, because you will not owe AMT, you will not be double taxed on your ISO exercise.
How ESO Can Help Reduce the Risk
Exercising stock options can be costly, and the risk of double taxation adds to the financial burden. One effective way to mitigate this risk is to work with ESO Fund to cover the total cost of exercising your stock options, including taxes. An indirect benefit of utilizing ESO for your option exercise is the potential for a disqualifying disposition, which can help eliminate much, if not all, of the Alternative Minimum Tax (AMT) and reduce your overall tax liability.
According to Section 422(c)(2) of the Internal Revenue Code, if you sell shares acquired from the exercise of ISOs within the same tax year as the exercise, you are exempt from paying AMT on phantom gains and instead pay ordinary income tax on your actual gains. In this scenario, ESO essentially facilitates installment payments for your shares. The first installment covers your exercise cost, the second provides funds for taxes, an optional third covers any secondary liquidity, and the final installment occurs at the time of terminal liquidity (such as an IPO or acquisition).
This approach allows you to retain unlimited upside potential while deferring taxes on the phantom spread (AMT) until the gains are realized. The value of this deferral is twofold: first, it ensures you have the funds for taxes when the realization occurs instead of pre-paying taxes on unrealized gains; second, it preserves your cash flow, which can be particularly advantageous given the increasing average time to liquidity for startup companies.
If you exercised your ISO stock options earlier this year and are concerned about the tax burden next year, ESO is an ideal solution, as it resolves the AMT issue and refunds your original exercise cost. However, keep in mind that your ESO transaction must occur in the same tax year as your option exercise to qualify for the AMT disqualifying disposition—so be mindful of the approaching December 31st deadline!
Next Steps
No repayments are due under ESO's program unless and until there is a liquidity event involving the company that issued the shares, such as a sale or IPO. Even then, you are not at risk because repayment is never higher than whatever the stock is worth at that time. See this page for more information on how to estimate the cost of paying AMT. For more information regarding ways to reduce stock option taxes or how ESO can benefit you, please contact us below.
