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What is a Qualified Disposition, What are the Tax Benefits, and When is it a Viable Strategy?

There are so many things to think about when dealing with your equity compensation package that all the requirements, rules and regulations just become a big blur of white noise. Breaking down the concepts into bite size topics allows you to make more informed long term strategy decisions. This article will simplify the most important concept of equity compensation, tax efficiency.

Making your equity compensation strategy tax efficient will provide you with the greatest increase of equity income among all the variables which you can control. A tax efficient plan can increase portions of the income you receive from equity packages by as much as 20%. This difference can stretch your total net worth quite a bit if you constantly take advantage of the lower tax rate. Receiving this lower tax rate is as simple as holding your investment long enough, to allow your holdings to qualify for your capital gains rate, versus your ordinary income rate.

For invested assets (including equity compensation shares), the period of time an asset is held differentiates that asset as either a long-term or short-term investment. Anything held for less than 365 days is considered a short-term investment. Anything held for 365 days, or more, is considered a long-term investment. The growth (or loss) in the value of the asset, from the purchase date, is considered either short-term gains (or losses) or long-term gains (or losses) Simple!

For tax purposes, any short-term gains will be taxed at your marginal ordinary income rate. Any long term gains will be taxed at your capital gains rate, which, until laws change, will always be lower. Simple math dictates that waiting for that capital gains rate, when you can, will net more income more consistently.

For some equity compensation packages, like Non-qualified Incentive Stock Options and Restricted Stock Units, this is where the lesson ends. If you receive your shares and have experienced a growth in value, you can receive better tax treatment if you can hold on to the position for a full year or more.

For other compensation plans, such as Qualified Incentive Stock Options and Employee Stock Purchasing Plans, there is another layer of rules you need to follow in order to receive favorable tax treatment. In these examples, you need to satisfy the rules of a Qualified Disposition. When doing so, not only will you receive any gains at a favorable tax rate, but you will also receive the bargain element (the difference in the fair market value and your discount price) at the favorable tax rate.

How do you satisfy the rules of a qualified disposition? In addition to the one-year holding period of stock, there is an additional time requirement. You must not dispose of the asset within two years of your grant date (the date you received the equity package). BOTH periods most be satisfied for the sale to be a qualified disposition.

Ex.1 Sam is granted 50 ISOs on 1/1/2019. He exercises the options on 1/1/2020 and then sells all shares on 1/2/2021. The sell date is both two years past the grant date and one year past the exercise date. He has satisfied the qualified disposition rules and will receive beneficial tax treatment.

Ex.2 Sam is granted 50 ISOs on 1/1/2019. He exercises the options on 12/1/2019 and sells the shares on 12/2/2020. While Sam held the shares for more than a year after he purchased them, he sold them less than two years since the grant date and will not receive favorable tax treatment.

Ex. 3. Sam is granted 50 ISOs on 1/1/2019. He exercises the options on 1/1/2021 and sells them on 1/2/2021. While Sam waited more than two years past the grant date to sell the shares, he did not hold on to them for one year after exercise and this would not be a qualified disposition.

As a visual, imagine your equity package as planet Earth, making trips around the sun. Once the equity package is granted to you the planet begins making a green trail. Once you purchase the shares, the planet beings making an additional blue trail. Until Earth has made two complete green circles and one complete blue circle around the sun, the qualified disposition rules have not been met.

While the rules seem simple, the dates are not always easy to track, and your life goals sometimes make waiting difficult, if not impossible. So, while the tax benefit can be a big benefit for individuals who receive equity packages, a strategy timeline still needs to be scripted and adhered to, in order to get the most out of your money.


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