Qualifying vs Disqualifying Disposition ESPP Explained

In the world of employee stock purchase plans (ESPPs), there are two types of dispositions: qualifying and disqualifying. A qualifying disposition occurs when you hold the stock for at least two years from the grant date and one year from the purchase date.

This is the key to avoiding taxes on the gain. A disqualifying disposition, on the other hand, occurs when you sell the stock within these timeframes.

You can have a disqualifying disposition if you sell the stock during the two-year or one-year holding period. This can happen if you need to sell the stock for financial reasons or if you're forced to sell due to unforeseen circumstances.

The tax implications of a disqualifying disposition are significant, with the gain being subject to ordinary income tax rates.

An Employee Stock Purchase Plan (ESPP) allows employees to buy company stock at a discounted rate, often with a 5% or 15% discount.

Employees can purchase stock through payroll deductions, typically over a period of 6 or 12 months.

The stock price is usually determined by the average price of the company's stock over a specified period, such as a month or a quarter.

The maximum amount of stock that can be purchased is often capped, and employees can usually purchase up to 10% of their annual compensation in stock.

Tax treatment differs significantly between Qualified and Non-Qualified ESPPs. ~80% of ESPP plans are Qualified, and ~20% are Non-Qualified.

With a Qualified ESPP, taxation is deferred and triggered when you sell the shares. The specific tax treatment depends on whether you have a Qualifying Disposition (QD) or Disqualifying Disposition (DD), and if you have a gain or loss upon sale.

You will owe state income tax on Qualified ESPP proceeds, although some states partially conform or opt out.

Taxation occurs on the share purchase date with a Non-Qualified ESPP. The discount upon purchase is taxed as ordinary income, and the increase/decrease in value thereafter is a capital gain/loss.

Taxation of ESPPs can be overwhelming, especially for those who are new to employee stock purchase plans. With Qualified and Non-Qualified plans, tax treatment differs significantly, and it's essential to understand the nuances of each plan type.

Qualified ESPPs are the most common, making up about 80% of all ESPP plans. With a Qualified ESPP, taxation is deferred until the shares are sold, and the tax treatment depends on whether it's a Qualifying Disposition (QD) or Disqualifying Disposition (DD).

A Disqualifying Disposition occurs when ESPP shares are not held for at least one year after the purchase date and two years after the offering date. In this scenario, the amount of discount received is taxed as ordinary income, and the gain on sale is taxed as capital gains.

Taxation Complexity can be further complicated by the lookback provision, which determines the purchase price based on the lower of the beginning or ending price. This can result in a better tax result with a disqualifying disposition in a down market.

Here's a breakdown of the tax implications for a Disqualifying Disposition:

In contrast, a Qualifying Disposition requires holding the shares for at least two years after the grant date and one year after the purchase date. The taxes triggered upon sale depend on the gain or loss realized.

A Qualifying Disposition can provide significant tax benefits, especially for high-income employees. For example, if an employee purchases shares at $17 per share and sells them at $30 per share, the $13 per share gain can be taxed at a lower rate as long-term capital gains.

Most state taxes fully conform to federal tax treatment for Qualified ESPP proceeds, but some states partially conform or opt out, so it's best to check with your state's tax rules regarding ESPPs.

Income taxes are not withheld upfront from Qualified ESPPs, but you'll still owe taxes when applicable.

Qualified ESPPs are statutory/qualified, which means they're not subject to FICA (Medicare and Social Security) taxes.

You won't have to worry about FICA taxes being withheld from your Qualified ESPP proceeds.

A qualified disposition occurs when ESPP shares are held for at least two years after the grant date and one year after the purchase date.

The taxes you trigger upon sale depend on the gain or loss you realize when you sell the shares. For a qualifying disposition, any discounted purchase price due to a lookback provision is taxed as long-term capital gains.

The benefit of a qualified disposition is that it generally allows more of the income from the spread on the purchase to be treated as capital gain and less as ordinary income.

The spread on purchase is the difference between what the employee pays for the share and what it is worth on the date of purchase.

Here's a comparison of taxes owed on a disqualifying disposition and a qualifying disposition:

However, the taxes owed are calculated differently for each type of disposition. For a disqualifying disposition, it's just the ordinary income per share multiplied by the employee's ordinary income tax rate. For a qualifying disposition, you multiply the ordinary income and capital gains per share by their respective tax rates, then add the results together.

For example, Emily owes $315 in taxes on a disqualifying disposition, compared to $238 on a qualifying disposition. That's a tax savings of $77.

A disqualifying disposition occurs when ESPP shares are not held for at least one year after the purchase date and two years after the offering date. This can result in a higher tax bill for the employee.

You'll owe ordinary income tax on the discount received on the purchase date, including any discount via the lookback provision. This tax is calculated as the discount amount multiplied by your ordinary income tax rate.

The remaining profit or loss from the sale of the shares is taxed as capital gains. If the sale occurs more than one year after the purchase date, it's considered long-term capital gains; otherwise, it's short-term.

Here's a breakdown of the taxes owed on a disqualifying disposition:

In Example 4, Emily, who is in the 22% tax bracket, owes $1.43 in taxes per share on a disqualifying disposition. This is calculated as the ordinary income tax rate multiplied by the discount amount.

Here's a comparison of the taxes owed on a disqualifying disposition and a qualifying disposition for Emily and Barbara:

In a qualifying disposition, you can save up to 20% on taxes compared to a disqualifying disposition, as shown in the example where the after-tax gain per share was $10.51 versus $8.71.

The tax savings is due to the fact that a qualifying disposition is taxed as both compensation income and long-term capital gain income, with the compensation income being taxed at 33% and the long-term capital gain being taxed at 15%.

In contrast, a disqualifying disposition is taxed as both compensation income and short-term capital gain income, with the compensation income being taxed at 33% and the short-term capital gain being taxed at 33%.

A qualifying disposition requires holding the stock for more than one year after the original purchase date and more than two years after the original offer date.

If you don't meet these criteria, it's a disqualifying disposition, and you'll be taxed on the entire gain as compensation income.

Here's a simple comparison of the two:

As you can see, a qualifying disposition can result in significant tax savings, making it a more attractive option for employees with ESPPs.

In real life, qualifying dispositions of ESPPs can make a big difference in your tax bill. A qualifying disposition occurs when you sell your stock at a gain of 2% or less of the purchase price.

Companies like Google and Facebook offer ESPPs with a 2% gain threshold, which is a common practice. This means that if you sell your stock after holding it for a year, you can qualify for the reduced tax rate on the gain.

The tax implications of disqualifying dispositions can be significant, however. If you sell your stock at a gain exceeding 2%, you'll be subject to ordinary income tax rates on the gain.

For example, if you sell your stock for a gain of 50% of the purchase price, you'll be taxed at your ordinary income tax rate, which could be as high as 37%.

Your company's stock purchase plan, or ESPP, is an excellent benefit that can provide a large gain on the back-end if you hold the shares long enough.

It's nearly a no-lose scenario, except in the exceptional circumstance that your company goes bankrupt.

By giving up liquidity for a specific holding period, you can defer income until it's more advantageous to recognize it.

This could be after moving out of a high tax state, allowing you to minimize your tax liability.

It's essential to weigh the benefits of selling right away and diversifying your investments against holding onto your ESPP shares for a longer period.