On a lawyer’s listserv that I am a part of, an issue recently came up where an independent contractor was given stock options in a startup as compensation, but in the offer letter and the company records the contractor was given incentive stock options (ISOs). However, ISOs can only be granted to employee; independent contractors must receive non-qualified stock options (NQOs).
I’ve previously discussed both ISOs and NQOs, but to recap, ISOs and NQOs are IRS classifications, each of which has tax benefits flowing to a different party. For ISOs, the benefit flows to the employee — the employee need not pay income taxes on ISOs; instead, assuming the employee holds the options and the stock for the requisite minimum period and meets other conditions, the employee is only taxed on the difference between the exercise price and the fair market value at the time of exercise at the long-term capital gains rate (which is lower than the income tax rate). Conversely, holders of NQOs must include the value in their income (and must also pay the capital gains tax upon exercise); however, the issuer (employer) may deduct from its own taxes the amount that the option holder must declare in his or her income.
So what happens in the event an independent contractor is accidentally granted ISOs? The response from the listserv was that, generally speaking, because ISOs and NQOs are tax treatments, the options granted are really only NQOs, since the IRS will not recognize ISOs treatment for options granted to an independent contractor. Of course, there may be conditions in the actual offer letter or options themselves that may render them void in the event they are mislabeled, but in any event the contractor and company will want to clear up the confusion as quickly as possible. For one thing, the independent contractor needs to include the value of his or her options in his or her income; in addition, the company will certainly want to take advantage of the tax advantages granted to it by NQOs.
Moreover, the company will want to clear up the confusion in the event a question comes up regarding the independent contractor’s actual employment status; it is possible that the on-paper issuance of ISOs could be potentially used as evidence that an independent contractor was being treated by the company as an employee, especially if there are other factors that point to a misclassification. As I’ve previously discussed, misclassification can lead to significant back taxes, interest, and penalties for the employer.
In any event, this serves as a lesson to be careful when drafting stock option grants — ISOs can only be granted under certain requirements, so you will want to make sure that those requirements are met.