Can You Issue Employee Stock Option to Contractor or Consultant in the USA?

Some companies choose to offer stock options to independent contractors or consultants as a form of compensation. In these circumstances, the contractor or consultant has the opportunity to own company shares.

Stock options give the contractors or consultants the opportunity and the right to buy company shares at a predetermined price (the strike/grant price). Contractors or consultants who exercise their stock options eventually become the owners of company shares.

This practice is often seen in startups since they do not have access to large amounts of funds as larger companies do. By offering stock options, startups can encourage contractors and consultants to take more initiative and win their long-term loyalty.

Although contractors and consultants are outside parties, they have a major role in a company’s growth. When considering giving stock options to contractors, there are a few factors to think about.

In this article, we shall discuss various stock options that can be granted to US consultants and contractors, as well as the risks and benefits of issuing stock options to contractors or consultants.

Types of Stock Options

There are two main types of stock options

1. Non-Qualified Stock Options (NSOs)

Unlike ISOs, Non-qualified Stock Options (NSOs) can also be used with contractors and consultants and are not just limited to employees. Companies include incentive stock options (ISOs) in their compensation packages for high-level employees; they are also known as qualified stock options.

Generally, NSOs are not taxable events for contractors and consultants. The difference will, however, be taxed as income if the company has a readily ascertainable value and that FMV exceeds the exercise price. 409A will not apply to bona fide consultants (actively engaged in providing services and less than 70% of the revenue comes from any one company or group of companies).

If the stock options are exercised, the spread will be taxed as income. In case the stock is sold, the sale price minus tax basis (exercise price + spread) is taxed as capital gain or loss. If stock is held for longer than one year, the long-term capital gains rate applies.

Private companies sometimes partly use NSOs along with or instead of cash, to compensate consultants and independent contractors. The size and terms of these grants can differ from those made to employees and must be considered in negotiations. These options or shares could increase in value significantly if the company goes public or is bought. They can lose all of their value if the IPO or merger never takes place.

2. Restricted Stock Options

Restricted Stocks for US Consultants and Contractors are based on vesting stock plans. They are given out by employers to independent contractors who achieve specific objectives or work for the company for a predetermined period of time. Once they are vested, restricted stock options are recognized as income and have a fair market value; a portion of the shares is withheld to cover taxes.

The remaining shares are retained by the stockholders for their own use. Restricted stock options give their owners a stake in the business once their stock has fully vested. They are similar to regular stocks, with the difference that shares must be bought on the day they are issued.

With regard to tax, in case of issuance, tax is on the difference between the fully vested stock’s FMV and the purchase price, if an 83(b) election is not made. Assuming 83(b) election is made, tax is on the difference between FMV and purchase price of all shares, vested and unvested. In the case of sale of stock, capital gain or loss is determined by the difference between the sale price and the acquisition price. The long-term capital gains rate is applicable if stock is held for more than a year.

Benefits and Risks of Stock Options for Contractors or Consultants

The benefits

• The major benefit of stock options for contractors or consultants is that they feel more involved with the company. Contractors or consultants feel more connected to the startup, its employees, and its success when they own a part of the company they are hired to perform work for.
• Contractors or consultants can invest in stocks without paying broker costs thanks to company stock options.
• Employers are free to offer any number of stock options because there are no limits on their value. If contractors or consultants decide they do not wish to hold all of those stock options, NSOs may be transferred to others, such as family members and nonprofit organizations.

The risks

• It can occasionally be difficult to meet the requirements of the company before stock options become vested. The NSOs will not actually belong to the contractors or consultants until they have vested.
• NSOs are taxed when they are exercised and sold rather than when they are granted or vested. Ordinary income tax will be due on the difference between the stock’s market value and the exercise price.
• Unlike regular publicly traded stock options, NSOs do not have a secondary market. The NSO will lose all of its value if the market price is less than the exercise price.

Benefits and Risks of Stock Options for Employers

The benefits

• Employers can maximize the amount of money they retain for business purposes by using stock options rather than paying contractors or consultants directly.
• Stock options also boost retention and loyalty. If contractors have a direct financial interest in the firm, they are more likely to be concerned about the long-term success of the company. This “ownership mindset” fosters a contractor’s motivation to work productively to achieve business goals.
• The leading contractors in their field are frequently in high demand and expensive. Startup owners typically lack the funding necessary to compensate top-tier contractors in the early stages of their companies, in contrast to large corporations. But founders might be in a special position to provide contractors an ownership opportunity, something most big businesses can’t match. In order to compete for the services of the best contractors in the industry, paying in equity may be an option.

The risks

• Employers are most at risk from dilution. Dilution reduces the employer’s control within the company and, over time, can be quite costly for shareholders.
• Stock options can be hard to evaluate, which can lead to excessive levels of remuneration for subpar company results.

Final Thoughts

Startups can grant stock options to contractors or consultants in the US, but contractors or consultants must think about how the stock options‘ vesting, taxation, financial planning, and investment management fit into their own personal financial plans.

trica equity is a trusted partner of over 600 startups for stock options and cap table management. If you’re looking for effective stock options and cap table management for your company, check out our offerings at trica. Book a demo today.