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An explanation of selling ISO stock before the end of the special holding period.
When you exercise a nonqualified option you have to report and pay tax on compensation income. You don't report compensation income when you exercise an incentive stock option — and if you hold the stock long enough, you'll never report compensation income from that stock. Of course, you'll have to report a capital gain if you sell the stock for a profit.
There's a catch. If you don't hold the stock long enough, you've made a disqualifying disposition. You'll have to report some or all of your gain as compensation income, which usually means paying a much higher rate of tax.
To avoid a disqualifying disposition you have to hold the stock you acquired by exercising your ISO beyond the later of the following two dates:
Many employers don't permit exercise of an ISO within the first year after the employee receives it. If that's the case you don't have to worry about the holding more than two years after the date your employer granted the option.
If you hold the stock long enough to satisfy this special holding period, then any gain or loss you have on a sale of the stock will be long-term capital gain or loss. You won't be required to report any compensation income from the exercise of your option.
If you fail to satisfy the holding period described above, your sale or other disposition of the stock is considered a disqualifying disposition. In this case you'll have to report compensation income as described below.
Everyone understands that a sale of the stock within the special holding period results in a disqualifying disposition. It's important to recognize that many other types of transfers can also result in a disqualifying disposition, for example:
Certain events do not give rise to a disposition for purposes of these rules, however:
A transfer to a spouse (or to a former spouse in connection with a divorce) is a special case. This is not considered a disqualifying disposition. Following such a transfer, the transferee spouse is subject to the same tax treatment as would have applied to the transferor. The transferor spouse should provide records needed to determine when the special holding period will be satisfied, the cost basis of the shares and the value of the shares at the time the option was exercised.
The tax consequences of a disqualifying disposition apply in the year the disposition occurs. You aren't supposed to go back and amend the return for the year you exercised the option, if that was an earlier year.
If your disqualifying disposition is a sale of your shares to an unrelated person without a "replacement purchase" (see below), your tax consequences are as follows:
If you had a disqualifying disposition from a transaction other than a sale to an unrelated person (such as a gift to someone other than your spouse, or a sale to a related person other than your spouse), or you bought replacement shares within 30 days before or after your sale, it's possible that the rules for that type of transfer don't permit the deduction of losses. If your disqualifying disposition comes from a type of transaction where a deduction for losses is not permitted, the following rules apply:
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