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Compensating independent contractors with company stock can raise classification issues
In some situations companies choose to pay independent contractors with company stock in the form of stock options, restricted stock or outright stock grants. This is particularly common among startups that do not have access to a lot of cash or private companies that intend to be publicly traded in the future. However, companies can offer stock to any independent contractor.
In deciding whether it is a good idea to pay an independent contractor with company stock, companies should consider two key strategic issues by making sure that:
•Contractor ownership of stock (whether through a restricted or outright stock grant or stock options) does not create a conflict that pits the contractor’s interest against the interests of the company or the other shareholders.
•The amounts of stock involved never represent a large enough percentage of the company to create an issue over who controls the company.
There are several elements to consider when developing a stock-based compensation agreement with a contractor. No matter what the situation, companies should consult with tax and legal counsel to make sure these arrangements comply with laws and regulations and to understand the full tax consequences for those involved.
Who Gets Stock?
In many cases stock-based compensation arrangements involve consultants the company hires for a specific project. It is up to the contractor to determine whether he or she is willing to give up some cash payment in return for some form of company stock. For example, if a consultant earns $100 an hour, a company might offer to pay $90 in cash and $10 in stock. “From the company’s perspective, this offer becomes a pitch to the consultant, similar to the pitch that [it] would make to a venture capital investor to bring cash into the company,” said John Beck of BeckCFO in San Jose, Calif. As a part-time CFO for startups, Beck has both structured these agreements and been paid with stock as a consultant.
The reasoning behind the offer is clear. “When a consultant is handling a technical role that is important to the company or is working close to full time over a number of months, offering stock can reduce the cash outflow required to pay for that consultant,” said Beck. “There is also the hope that contractors will be more invested in the outcome” when they are paid partly in company stock.
What to Offer
The type of stock to offer to contractors is an important decision for businesses. “Most companies would prefer to grant a simple regular stock option with provisions similar to the stock options they grant their own employees, which typically involve a four-year vesting period,” said Beck. However, not all contractors are willing to accept that as compensation for several reasons, including the cost of exercising stock options and any tax implications. In these cases companies may be able to seek out a middle ground, such as offering a shorter vesting period of one or two years or changing the arrangement to a restricted stock grant. But if the agreement in the company’s formal stock option plan forbids changes to vesting schedules, the organization could focus negotiations on the number of shares awarded or the terms under which shares vest.
Set the Price
One issue to consider is how to determine the price or value shares if the company is private and there is no market for the stock. In this situation the IRS requires a
409a valuation, to set the value of the stock awarded to the company’s employees, which is also the price for any stock-based compensation given to independent contractors.
Manage the End
Companies need to determine what happens to stock-based compensation when they formally terminate a contractor relationship. “I encourage companies to prepare a simple form letter that goes to the consultant reminding them of the responsibility to exercise the stock option within the required window,” said Beck. “This is the same kind of letter a terminated employee would receive. In both cases the individual has to either exercise [the] option or lose all rights and privileges of the option” after a certain time.
Consider Classification Issues
One final issue to keep in mind when offering an independent service provider stock-based compensation is any potential effect on that party’s classification as a contractor. “This does not just involve the IRS,” said Michael Newman, a partner with law firm Barger & Wolen LLP in Los Angeles. “There are multiple entities, jurisdictions and regulatory authorities interested in the question of classification.”
Determining employee or contractor classification focuses on basic and subsidiary questions that are not defining in themselves but can weigh in on one side or the other. “Paying in stock becomes one of the factors to be considered,” Newman said, as it could imply, if other factors are present, a relationship closer to employer/employee than company/contractor and, thus, present the risk of having contractors reclassified as employees.
Companies will have a stronger case for maintaining a contractor classification, Newman noted, if paying contractors in stock is the industry standard—or at least a more common practice.
Joanne Sammer is a New Jersey-based business and financial writer.
Related SHRM Articles:
Reducing Liability for Company Stock in 401(k) Plans,
SHRM Online Benefits, March 2013
Ensure the Strategic Use of Stock-Based Pay,
SHRM Online Compensation, May 2012
SHRM Online Compensation Page
SHRM Online Outsourcing & Vendor Relations Resource Page
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