What is it:
A disqualifying disposition is a sale of shares from an incentive stock option (ISO) that comes too early to get the ISO's tax advantage. It happens when you sell, give away, or make most other transfers of the shares before both ISO holding periods have passed: two years from the grant date and one year from exercise. The spread at exercise is then taxed as ordinary income, much like a non-qualified stock option (NQSO), and any gain beyond the spread is taxed as a capital gain.
Why does it matter:
Selling early typically means a higher tax bill. Take the same example as a qualifying disposition: a $10 strike price, exercised when the shares are worth $14, sold at $30. In a disqualifying disposition, the first $4 per share is taxed as ordinary income instead of as long-term capital gains. If you also sold within a year of exercise, the remaining $16 is a short-term capital gain, which is taxed at ordinary income rates too. If you sell for less than the shares were worth at exercise, the ordinary income is generally limited to your actual gain on the sale.
What do people most often get wrong:
People often don't realize that exercising and selling at the same time counts. A cashless exercise or any same-day sale of ISO shares is always a disqualifying disposition, since the shares are sold the moment they're acquired. The spread is taxed as ordinary income, much as if the options had been NQSOs, even though they were labeled ISOs.