Who doesn’t love a great tax break? You and I can’t personally reverse a bear market or revise Federal regulations. But we do get to decide when and how to exercise, hold, and sell our incentive stock options (ISOs), dictating whether we have a qualified disposition or disqualified disposition. Why not make best use of your tax-planning powers when you do?
At a glance, it would seem qualified dispositions are the way to go:
- Qualified dispositions: Proceeds are taxed at (usually lower) long-term capital gains rates.
- Disqualified dispositions: Proceeds are subject to various (usually higher) tax rates.
Fewer taxes are better, right? True enough. But have you also integrated your tax planning with your financial planning and investment management, to optimize overall results? If you haven’t, there’s an important caveat often lost in all the tax-saving excitement:
By taking a qualified disposition, you’re also taking on a concentrated risk. If the stock price drops in the year or so after you exercise your options but before you sell the stock, you may lose more in share value than any tax savings are worth.
Is this a risk worth taking? Maybe yes, maybe no. Or maybe a hybrid approach will make the most sense. Today, I’ll show you how to decide.
Incentive Stock Options: Qualifying and Disqualifying Dispositions
First, let’s review how ISO dispositions work in general.
Qualifying Dispositions/Tax Rates: To make a qualifying disposition, the final stock sale must occur:
- At least 2 years past the ISO grant date, AND
- At least 1 year past your exercise date
If you meet these hurdles, any gain on the stock sale is taxed at favorable long-term capital gains rates. In 2022, these rate tiers were 0%, 15%, and 20% (not including potential net investment income tax).
Disqualifying Dispositions/Tax Rates: A disqualifying disposition is any final stock sale that does not meet both requirements above. If you perform a cashless exercise and sell, your profits are taxed as ordinary income. Other non-qualifying dispositions may be taxed as a combination of short- and long-term capital gains. In 2022, the seven ordinary income rate tax brackets were 10%, 12%, 22%, 24%, 32%, 35%, and 37%. Depending on the rest of your taxable annual income, and the size of your disposition, portions of your profit could be taxed at any or all of these rates.
ISO Disposition Illustration #1: A (Simplified) Qualified Disposition
Now, back to the risks you face in a qualifying disposition. Again, after you exercise, but while you hold your shares for at least a year, their price can be volatile—up or down. No problem if the price goes up. But if it goes down and stays there, you’ll wish you had exercised and sold the stock right away.
To illustrate, we’ll create three hypothetical examples, beginning with a qualified disposition. We’ll intentionally simplify our first example, on two counts: First, we’ll assume the stock price is exactly the same at exercise and at final sale a year later. This is highly unlikely in real life, but it gives us a baseline to work from. We’ll also exclude Alternative Minimum Tax (AMT) considerations, to isolate the taxable impact of qualified vs. disqualified dispositions.[1] Here are the rest of our assumptions:
- Incentive Stock Option: 10,000
- Strike (Exercise) Price: $5.00
- Current FMV: $50.00
- Future FMV: $50.00
- Long-Term Capital Gains Rate: 20%
Next, we’ll calculate the after-tax value of the incentive stock options upon final sale. Said another way, how much after-tax profit, will you realize if you exercise your incentive stock options, hold the shares for more than a year, and sell them as a qualified sale, subject to long-term capital gains rates? Here are the calculations and results:
“After-Tax Value” = [“Number of ISO” x (“Future FMV” – “Strike Price”)] x (1 – “Tax Rate”)
= [10,000 x ($50 – $5)] x (1 – 0.20)
= $450,000 x 0.80
= $360,000
In this example, the after-tax value is $360,000. This is money you get to keep—to fund personal financial planning goals, retirement, college, a vacation home, your tax preparation bills, etc.
ISO Disposition Illustration #2: A Disqualified Disposition
In our next hypothetical example, let’s assume you take a cashless exercise and sale of all your ISOs:
- Incentive Stock Option: 10,000
- Strike (Exercise) Price: $5.00
- Current/Final FMV: $50.00
- Ordinary Income Tax Rate: 37%
We can follow the same formula, adjusting the tax rate to reflect a higher ordinary income due to the disqualifying disposition.
“After-Tax Value” = [“Number of ISO” x (“FMV” – “Strike Price”)] x (1 – “Tax Rate”)
= [10,000 x ($50 – $5)] x (1 – 0.37)
= 450,000 x 0.67
= $301,500
In this example, the after-tax value is $301,500.
ISO Disposition Illustration #3: Additional (More Realistic) Qualified Dispositions
Following the analyses above, the qualifying sale still seems preferred, given its higher after-tax proceeds and lower long-term capital gains rates. However, we’ve not yet accounted for more realistic scenarios, in which the stock price either rises or falls after you execute your ISOs but before you sell your shares.
If the stock price is higher when the 1-year mark is reached, that’s good news. A qualifying disposition becomes an even better relative value. However, if the stock price is lower, a disqualified disposition may become the preferred strategy, at least with 20/20 hindsight.
To illustrate, let’s calculate the after-tax proceeds of a qualified disposition, assuming a range of lower final sale prices.
- Incentive Stock Option: 10,000
- Strike (Exercise) Price: $5.00
- Current FMV: $50.00
- Future FMV: $50.00
- Future FMV 2: $45.00
- Future FMV 3: $40.00
- Future FMV 4: $35.00
- Future FMV 5: $30.00
- Future FMV 6: $25.00
- Long-Term Capital Gains Rate: 20%
Using our formula, we see the following:
| Sale Price | Gross Proceeds | Taxable Amount | Tax Due | After-Tax |
| $45.00 | $450,000 | $400,000 | ($80,000) | $320,000 |
| $40.00 | $400,000 | $350,000 | ($70,000) | $280,000 |
| $35.00 | $350,000 | $300,000 | ($60,000) | $240,000 |
| $30.00 | $300,000 | $250,000 | ($50,000) | $200,000 |
| $25.00 | $250,000 | $200,000 | ($40,000) | $160,000 |
As the final sale price drops, so does the after-tax value. At a final sale price of $45 per share, the after-tax value is $320,000. That’s still better than the $301,500 after-tax value of the disqualified disposition in illustration #2. But at $40 per share, the after-tax value drops to $280,000. At this price point, you may have been better off selling the stock at execution and paying the higher upfront tax rate.
Looking at this another way, for the qualified sale to “win,” the stock can withstand a 10% price drop, from $50 to $45 per share. If it declines by 20% (from $50 to $40 per share), the disqualifying disposition is preferred. This begs the question: If you exercise your ISOs at $50/share, what is the break-even final sale price where the qualified and disqualified dispositions are equal? Based on after-tax value, the answer is (drumroll, please) $42.6875 per share.
| Sale Price | Gross Proceeds | Taxable Amount | Tax Due | After-Tax |
| $42.6875 | $426,875 | $376,875 | ($75,375) | $301,500 |
General Principles, Personal Pursuits
Again, our simplified illustrations did not account for cash-flow and other planning issues related to the AMT and/or best use of your AMT credits. Both could impact your ideal choices. We also only compared two tax rates, 37% and 20%. Your actual tax rates may be different, with different break-even points.
As such, the take-away from our illustrations isn’t to fixate on a $42.6875 break-even share price, or any other particulars. Rather, it’s to demonstrate that the most “obvious” tax-friendly choice isn’t always such a no-brainer after all. In fact, when considering how to dispose of incentive stock options, it’s not uncommon to lead with tax planning alone—including how to navigate ordinary income, capital gains, and AMT tax rates and credits. Through this lens, the qualifying disposition may be given blanket approval, without accounting for the risk/reward tradeoffs you’re exposed to during a year of stock price volatility.
Qualifying or Disqualifying Incentive Stock Options: How Do You Decide?
The question remains: Is it worth seeking preferential long-term capital gains treatment on a potentially volatile stock? Or does it make more sense to simply exercise and sell your incentive stock options as a disqualifying sale, pay tax at ordinary income rates, and move on?
A More Integrated Approach: One way to solve the quandary is to include your incentive stock options as another funding source for your financial goals and objectives. In other words, rather than limiting your stock option planning to the tax ramifications alone, integrate it into your broad financial, investment, and tax planning efforts.
Once and Future Value: It’s also worth exploring the current and future value of your stock options. As illustrated above, it’s easy to know what they’re currently worth, but we can only guess at the future. By running some assumptions of your own, with a range of potential outcomes, you can better envision whether a qualified or a disqualified disposition seems like the better outcome for you.
Your Risk Tolerance: Beyond empirical analysis, it’s also a personal choice whether you’d rather keep the bird in hand (a disqualified disposition), or stretch for those in the bush (a qualified disposition).
Your Investment Mindset: Are your stock options more of a payment or a promise? If you mostly think of them as a financial reward for services rendered, you may prefer to exercise and sell them as soon as possible, so you can enjoy the fruits of your labor. On the other hand, if you’re optimistic about your company’s prospects (and can afford to take the hit if reality disappoints), you may want to pursue those potential long-term gains by exercising and holding your options as an investment.
Go Hybrid: As we mentioned at the start, whether to take a qualified or disqualified disposition does not have to be an either/or proposition. Sometimes, your best plan may involve exercising and selling some of your ISOs today, while exercising and holding others for future sale.
Qualified or Disqualified Distributions: Which Are Right for You?
I hope I’ve offered valuable food for thought about how to optimize the value of your incentive stock options. While a qualifying disposition may work in your favor if it all works out well, it’s important to recognize it can also work against you if the share price drops out from under you. As usual, there is no universal answer for everyone. But by now, you at least know the right questions to ask.
This material is intended for informational/educational purposes only and should not be construed as investment, tax, or legal advice, a solicitation, or a recommendation to buy or sell any security or investment product. The information contained herein is taken from sources believed to be reliable, however accuracy or completeness cannot be guaranteed. Please contact your financial, tax, and legal professionals for more information specific to your situation. Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Talk to your financial advisor before making any investing decisions. The scenarios discussed are hypothetical examples and are for illustrative purposes only. No specific investments were used in these examples. Actual results will vary
[1] The AMT is an additional concern when exercising and holding ISOs, as you may owe AMT taxes that year or have AMT credits to deploy. If you’d like to learn more, you can read here, here, and here.
