A disqualifying disposition is a sale, transfer, or exchange of ISO or tax-qualified ESPP shares that is executed before satisfying the holding period requirements of two years from the stock grant date and one year from the stock exercise date.
With an ISO, meeting the holding period requirements allows the spread (i.e., the difference between the grant price and the purchase price) to be taxed at long-term capital gains rates. If you make a disqualifying disposition, that spread will be taxed at your ordinary income rate.
With a tax-qualified ESPP, meeting the holding period requirements limits ordinary income taxation to the lesser of the spread between the purchase price and the fair market value (FMV) of the stock at the time of the grant or the purchase price and the FMV of the stock at the time of exercise, with all other gains taxed at the long-term capital gains rate. In the event of a disqualifying disposition, the spread between the grant price and the purchase price will be automatically taxed at your ordinary income rate. Further, any additional gain will be taxed as a short-term or long-term capital gain, depending on whether you held the stock for more than one year before selling it.
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