Smart Money Tips

Understanding Qualifying and Non-Qualifying ISO Dispositions

  • Selling shares acquired from employee stock options can earn favorable long-term capital gains taxation if specific timing requirements are met.
  • A disqualifying disposition happens when you sell a position quickly and then face potentially higher marginal tax rates.
  • Managing risks with ISOs and employer shares while paying a low tax rate is a careful financial planning balancing decision.

Timing matters when selling shares after exercising your company incentive stock options
(ISOs). Maximizing the value of this form of equity compensation can be tricky. Knowing the
tax rules while balancing what works best for your current liquidity needs and risk level often
requires the help of experienced financial planners. At Archer Investment Management, we
strategize with tech small business owners and individuals with significant stock options looking
to diversify their portfolios.

An Important Decision
Several common questions arise with various types of employee stock options. Many clients
want to exercise ISOs and sell shares while paying as little in taxes as possible. Thus, taking a
qualifying or disqualifying disposition is an important strategic choice.

What Are Qualifying and Disqualifying Dispositions?

For background, a qualifying disposition is a sale of assets that is treated favorably for taxation.
To earn a lower tax rate, the employee must sell at least one year after the exercise date (the date
options were exercised and shares were purchased) and two years after the ISO grant date (the
date ISOs were granted). Qualifying dispositions are taxed at relatively low long-term capital
gains rates – either 0%, 15%, or 20% depending on your annual taxable income. High-earners
might also face the additional net investment income tax.

A disqualifying disposition, however, typically faces higher marginal income tax rates, which
might be as high as 37% for those with high taxable income. Other non-qualifying dispositions
may be taxed at a combination of short- and long-term capital gains rates.

The amount of compensation income subject to ordinary income tax rates would be the
difference between the stock’s fair market value on the exercise date and the option’s strike price
if the ISOs were sold at a profit. Any amount above that difference is treated as a capital gain.

Viewing ISOs and Employer Shares from a Portfolio Perspective

So, it seems easy to wait it out to snatch a much lower tax rate when cashing in your stock
options, right? Not so fast. There are many financial planning considerations surrounding your situation. Liquidity needs, your overall portfolio’s risk and return profile, the valuation of the company, and changing tax rules are just some factors to weigh when choosing the optimal path. Moreover, another risk to keep in mind is the Alternative Minimum Tax (AMT), which can be triggered when exercising stock options.

What If the Stock Value Drops?

A critical risk with waiting to take a qualifying disposition is what might happen to the value of
your shares and options. For example, following the tech rout of late 2021 and 2022, many
employees paid in equity-based compensation saw their “on-paper” net worths plunge when
private stock was revalued lower. For those workers, continuing to hold shares with the goal of
taking a qualifying disposition did not work out well. Of course, the opposite can happen, and
the stock value can rise. This unknown factor is a significant risk. If the stock value plummets in
the one-year window after you exercise, but before you sell the stock, that loss might more than
offset any tax savings.

A Risk Mitigation Strategy

It does not have to be an all-or-nothing approach, though. The Archer team works with
individuals and couples to develop a plan to sell shares over time. Just as dollar-cost averaging
works during the accumulation phase of investing, it also does when exiting a position. By taking
quarterly sales over a few years after hitting the qualifying disposition timing requirements, we
can smooth out your net proceeds to avoid a worst-case scenario.

The Bottom Line

Incentive stock options can be a lucrative form of equity-based compensation, but a set of critical
risks comes with ISOs. Managing a concentrated position in your employer’s stock is a major
financial planning task; a single decision can cost you thousands of dollars if not done correctly.
We must balance the upside of tax savings of waiting to make stock sales with the downside risk
that something bad could happen to the value of your shares.

At Archer Investment Management, we provide people-focused financial planning for tech
industry professionals holding ISOs so they can confidently reach their long-term goals. We
would love the opportunity to develop a custom strategy for you. Click here to schedule a phone
call, and please visit us at Archer Investment Management.