What is it:
A qualifying disposition is a sale of shares from an incentive stock option (ISO) that gets the full tax advantage ISOs are designed to offer: everything above the strike price is taxed as long-term capital gains. To qualify, the sale, gift, or other transfer has to come after two holding periods have both passed. The first is two years from the option's grant date, and the second is one year from the date you exercised it.
Why does it matter:
Meeting both holding periods is the condition that unlocks the ISO's tax advantage. Suppose your strike price is $10, you exercise when the shares are worth $14, and you later sell the shares at $30 each. In a qualifying disposition, the full $20 per share is taxed as a long-term capital gain. Sell the same shares too early, and the first $4 per share of that gain is taxed as ordinary income instead.
What do people most often get wrong:
People often assume that holding ISO shares for a year is enough, since one year is the usual threshold for long-term capital gains. ISO shares have to clear two separate clocks, and the one that ends later is the one that counts. Which clock that is depends on how soon after grant you exercised. Your employer should send you Form 3921 after an ISO exercise, which records the dates and values you need to track both clocks.