Disqualifying disposition is the legal term for selling, transferring, or exchanging ISO shares before satisfying the ISO holding-period requirements: two years from date of grant and one year from date of exercise. If you sell, transfer, gift, or short the stock too soon, you lose the tax benefits of ISOs that occur with a qualifying disposition. The timeline below illustrates the concept of the holding period, showing how long you must keep the shares to prevent a disqualifying disposition and make a qualifying disposition at sale.
Transfers of ISO stock to a spouse, to a broker (without change of legal title), in a divorce, or after your death are not dispositions. However, a gift to someone other than your spouse, including a transfer to an irrevocable trust, is a disposition.
Your company receives a tax deduction when you make a disqualifying disposition equal to the amount of ordinary income you recognize for your early sale. It needs to report this income on your Form W-2. Therefore, companies use various methods to track stock sales. These methods include mandatory sale reports, surveys, and even requirements to keep the stock in an account at a certain brokerage firm or transfer agent until the holding period is completed.
See a related FAQ with examples of the tax treatment when you engage in a disqualifying disposition.