Stock options and equity compensations are a great offer for the contractors, allowing you to create a more attractive package to make them work for you. Employers can use them as awards, or to complement the salaries, while serving as an incentive for contractors, inspiring them to do their best for the company. They are safe and flexible enough, leaving CEOs and contractors with plenty of options to create a contract that satisfies both sides.
Attracting highly-skilled independent contractors from all over the world can become quite a difficult task, and business owners need to consider spicing up the packages with something special, valuable, and promising.
One of the tactics that confident entrepreneurs and CEOs pick is offering the independent contractors a share of the company stock. It can be provided in addition to a competitive salary, or to make up for lackluster financial compensation; sometimes, early-stage startups and private companies don’t have a lot of money at their disposal. Hoping that the enterprise will skyrocket when it goes public or merge with a powerful player on the market, contractors accept this offer. In the best-case scenario, company’s stock will get highly valuable and bring a fortune to the stockholders.
With huge potential gains, however, come certain risks: if the whole company flunks, stocks become worthless and they’re left with their salaries only.
In case you are one of the employers who want to learn more about this compensation model, or an independent contractor wondering if accepting company stock options is the right move, stay tuned!
The article before you will guide you through all of the legal requirements, bits and pieces of offering/ accepting the company’s stock. This includes:
- What are stock options, shares, and restricted stocks
- What is stock option granting and vesting
- How can shareholders exercise their stock options
- What can shareholders do with their stocks
- Tax consequences tied to different types of stock options
- How to report stock option compensation paid to independent contractors?
What are the employee stock options?
The first important distinction to make is one between stock options and actual company shares.
Owning company shares means that you own a part of the company, i.e. you have equity in the said company. This means that you’ll receive a proportionate amount of dividends when the company makes a profit.
When a company offers the stock options, they are actually presenting the other party with a right and opportunity to purchase company shares for a specific price called strike price/ grant price. This price is usually the fair market value of the shares at the time the contractor is given stock awards.
To exercise the stock options means to buy them for a stock price mentioned above — and when you do it, you officially own company shares. The “options” part of the name comes from the fact that stock option owners aren’t ever required to exercise them: contractually, the offer stands, but the contractor never has to buy them.
This is attractive both for the company and the contractor. Companies get a contractor that works hard and is personally invested in their success, with a chance to offer non-financial equity compensation in times where every dollar counts. On the other hand, contractors get to grow together with the company and receive benefits that outnumber the contractors' salaries by a lot if the company shares become valuable.
However — stock options cannot be exercised before they are vested (unless you have the early exercise right — to exercise the stock options before they vest).
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Stock option granting and vesting: how stock options work
Stock options are given to employees or contractors in the shape of a grant: as an award, incentive or as a part of the compensation/ in place of the financial compensation. Stock option grants contain the details such as type of stocks, number of shares you receive, strike price, and vesting schedule.
Vesting is the process of acquiring the right to exercise the stock options. This means that companies require the contractors to stay with them for a certain period of time or meet a certain performance milestone, until contractors come to a “vesting cliff” — a point in time when you can rightfully start exercising, and your stock options are vested. Then, contractors can buy the actual company shares.
Options usually vest gradually. For example, the stock option package includes a four-year vesting period, a one-year vesting cliff, and a total of 40,000 stock options.
After a year spent with the company, the contractor may obtain 10,000 stock options; a two-year mark allows them to obtain 20,000, for three years, 30,000, while a full four-year period means that the contractor is eligible to obtain all the options promised.
If contractors leave the company before their stock options are vested, they belong to the company again. This is why vesting acts as a great employee retention tool: the owners of vested stock options have nonforfeitable rights to exercise them.
Note that stock options have an expiration date: this date is noted in the contract, and options usually expire 10 years after the grant date.
Exercising the stock options
Stock options kind of act as a promise of a future value before they’re vested, and until they’re exercised, they don’t have real value.
Once contractors exercise the stock options, they have full ownership. Contractors can then choose to hold them, if they predict or hope the value of the stock will continue to grow over time. Other options include:
- Selling all the stock options immediately, known as exercise-and-sell transaction
- Exercise-and-sell-to-cover transaction, where people can sell the amount of shares to make up for the purchase and keep the rest
When to exercise the stock options?
Stock option owners can exercise them whenever they want, provided that they’re vested.
The smartest course of action would be to wait until the company stock market value exceeds the grant price. But, the company needs to go public first and has the initial public offering (IPO) — meaning that the general public is now able to buy the company stocks, and the shares are available for open market trade.
The best part? The grant price is fixed, and that’s what makes the profit for the stock owners when they exercise and sell the shares.
What are restricted stocks?
Instead of stock options, companies can offer restricted stock units (RSUs) or restricted stock awards (RSAs).
Restricted stock units (RSUs) are company shares issued through the vesting stock plans. Employers give them to full-time employees or independent contractors for reaching certain milestones or staying with the company for a certain period of time.
Upon vesting, RSUs have a fair market value and are considered as income: a portion of the shares is withheld to pay the income taxes. Stock owners keep the remaining shares and can use them as they please. After stocks are fully vested, RSUs provide its owners with interest in company stock.
RSAs are the same, with one exception — you purchase the shares the same day they’re granted.
Therefore, RSUs are highly valuable for employers — not only as a part of an employee incentive plan but to help them take care of income taxes as well.
How are the stock options taxed?
Stock options aren’t taxable until independent contractors choose to exercise them, no matter if they've vested or not.
For tax purposes, there are two types of stock options:
- Incentive stock options (ISOs)
- Non-qualified stock options (NQSOs)
Since the taxes and tax rates also depend on the actions you take, we’ll describe a few scenarios and corresponding tax treatment below.
When you exercise and sell the stock options simultaneously, you’ll need to pay ordinary income tax for the difference between the grant exercise price and the fair market value of the company shares — this goes for both ISO and NSO.
Selling the shares within a year of exercising the stock options
For ISO, you’ll need to pay ordinary income tax on the spread and short-term capital gains tax (for any profit that exceeds that amount) — if you sell the shares for more than the grant price you’ve paid. If you sell them for less, you need to pay just ordinary income tax.
For NSO, you’ll have to pay short-term capital gains tax on the profit you’ve made by selling the options.
Selling the shares after exercising and holding them for a year or more
ISO tax implications: you probably won’t have to pay any taxes upon exercising the stock options; after you sell the shares, you’ll likely need to pay the long-term capital gains tax on the profit made by selling the options.
However, you may have to pay the Alternative Minimum Tax (AMT) if you don’t sell the shares in the year of exercising them. We suggest you take a look at the official Instructions for Form 1040 and 1040-SR by the IRS to learn if you’re subject to the ATM.
NSO tax implications: you’ll have to pay long-term capital gains tax on the profit made when selling the options.
How to report stock option compensation paid to independent contractors?
Back in 2018, the Financial Accounting Standards Board (FASB) updated the rules by issuing the Accounting Standards Update (ASU).
Under these new rules, the guidance is the same for employees and non-employees alike, including the independent contractors.
The company shares awarded to independent contractors are measured according to the estimate of the fair value of the equity the company has to issue at the date of the agreement (between the company and the stock recipient).