An employee makes a disqualifying disposition of stock acquired under an incentive stock option (ISO) or a qualified employee stock purchase plan (ESPP) when he sells the shares before the end of the required holding period, which is two years from the grant date and one year from the date of exercise. A disqualifying disposition deprives an employee of otherwise favorable tax treatment.

If an employee makes a disqualifying disposition of ISO shares, the applicable portion of the ISO is treated as a nonqualified stock option, and assuming that the ISO shares are sold at a profit, he will recognize ordinary income on the excess of the fair market value (FMV) of the shares on the date of exercise over the aggregate exercise price. This income will appear on the employee's IRS Form W-2, and the employer can take a tax deduction on the amount of ordinary income recognized by the employee. Excess proceeds receive capital gain treatment. For more information on the taxation of disqualifying dispositions of ISO shares, see Practice Note, Overview of the Taxation of Equity Compensation Awards: Incentive Stock Options.

If an employee makes a disqualifying disposition of shares acquired under a qualified ESPP, he will recognize ordinary income at the time of the sale on the excess of the FMV of the shares on the purchase date over the purchase price. This income will appear on the employee's IRS Form W-2, and the employer can take a tax deduction on the ordinary income recognized by the employee. Capital gain or loss is also recognized in the year of the sale in an amount equal to the difference between the sale price and the sum of the purchase price and the amount of ordinary income calculated above. For more information on the taxation of disqualifying dispositions of shares acquired under an ESPP, see Qualified Employee Stock Purchase Plans Checklist.