ISO or NSO / NQSO- exercise, RECEIVED NO TAX FORMS and the stock option contract refers to the plan as ISO, even though I was an Independent Contractor

[tax-conundrums]

I have a deep burning tax question I was hoping someone here with some concrete knowledge of this situation could help answer. I was an Independent Contractor at a company that offered me Stock Options. I exercised (only purchased) the stock options last year at the end of Jan. 2021. The stocks were restricted stocks so I could only purchase them, not sell them, and they were also Canadian Stocks. The stock option agreement refers to the plan as an Incentive Stock Option (ISO) plan even though I was an Independent Contractor for the company.  I would assume being an IC would have made the stock options fall into the category of being an NSO / NQSO for me, which has immediate tax implications, (i.e. if it is an NSO for me, from everything I've been reading, I am supposed to report the gain between the strike price and FMV at the time of exercise, and it becomes reportable income in the year of the exercise). However, I do remember there being talk of the company treating IC's as employee/W2's for like 1 day or so just for the purpose of these stocks, but I never received a W2 or 1099 from them in relation to the exercise of these stocks or even for any work in 2021 becasue the last time I worked for them was in 2020. I had a year to exercise the option after I left the company in 2020 and took advantage of that in 2021. I am certain the company is still treating this exercise as an ISO and again, I RECEIVED NO 1099 or W2 for this past year when I exercised them, and I don't expect to get one until I sell the shares eventually. I emailed the CEO last year in regards to this being ISO or NSO and his answer was elusive wherin all he would say is please check with an accountant, but typically you do not have a tax liability until you sell the shares and have a capital gain. No taxable event has taken place while you hold them.  

MY BIG QUESTION IS THIS: Do I need to report the exercise as an NSO stock option exercise this year on my taxes (even though the stock option agreement refers to these stocks as ISO stocks), or do I just wait until I sell these stocks and get a 1099 or W2 or something from the company and deal with it all then??? I just want to do the right thing. Please help. 

[GeorgeM777]

No, there is nothing to report until you sell your ISO shares, at least in terms of gain or loss.  When you sell the ISO shares, you will probably not get anything from the company as you were not there employee and moreover, it appears you are not working there anymore.  However, the firm that effects the sale for you will likely send you a 1099-B or similar statement showing the sale proceeds, the sale date, and the sale price per share.  However, the firm that sells the ISO shares for you will probably not know your cost basis in the ISO shares, and therefore, the cost basis on the Form 1099-B or similar statement may likely show 0 as your cost basis.  Therefore, it is important for you to keep records showing your cost basis in the ISO shares as you will need this information to determine your gain or loss when you sell your ISO shares. 

Because you still hold the ISO shares, you will need to enter such information into TurboTax in order to determine whether you owe the alternative minimum tax (AMT).  TurboTax will do the calculations for you, therefore, all you need to do is to enter the information 

In TurboTax online, to enter your ISO and AMT information, follow these steps:

1. Go to Income & Expenses.
2. Scroll down the page to Investment Income, and if necessary, click on the drop-down arrow to reveal more subcategories.
3. Select ISO Exercise and Hold.
4. Respond to the questions when prompted.

In TurboTax desktop the process is essentially the same.  That is, in the income section, you will scroll down to the Investment Income section and select the subcategory ISO Exercise and Hold. 

@tax-conundrums

[tax-conundrums]

http://www.firstventurelegal.com/2013/05/24/so-you-accidentally-granted-incen[product key removed]ns...).

It appears I still have treat these as NQSO/ NSO's. 

[tax-conundrums]

http://www.firstventurelegal.com/2013/05/24/so-you-accidentally-granted-incen[product key removed]ns...).

[tax-conundrums]

“So You Accidentally Granted Incentive Stock Options to an Independent Contractor…”

MAY 24, 2013 BY JAMES JOHNSON 

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.

[tax-conundrums]

"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."

It appears a bunch of lawyers from a listserv back in 2013 have stated this must be treated as an NQO, "since the IRS will not recognize ISOs treatment for options granted to an independent contractor" 

If this is the case, I'd rather stay on the safe side and report it as an NQO.

[GeorgeM777]

As a follow-up to the previous comments, you raise certain issues which are important and need further clarification which is probably beyond the scope of the advice we can provide.  Whether you were truly an independent contractor versus an employee is a question of fact.  As the IRS has previously stated,  

"In determining whether the person providing service is an employee or an independent contractor, all information that provides evidence of the degree of control and independence must be considered....There is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor and no one factor stands alone in making this determination. Also, factors which are relevant in one situation may not be relevant in another."

Here is the link to the IRS webpage from which the above quoted information was obtained.

Independent Contractor or Employee

A very important factor in determining whether you were an employee versus an independent contractor is the level of control the company had over you and the work you performed.  In this regard, the IRS has stated,

"Under common-law rules, anyone who performs services for you is your employee if you can control what will be done and how it will be done. This is so even when you give the employee freedom of action. What matters is that you have the right to control the details of how the services are performed."

Employee (Common Law Employee)

Lastly, leaving aside the independent contractor/employee issue, you did receive ISOs and whether that was correct or not, the fact remains that is what you have.  Treating them as if they were NQSO, while that may appear to be the safer option, may not be consistent with the company's incentive compensation plans and whatever agreements/contracts they have in place with respect to their ISOs and NQSOs (assuming they even offer NQSOs).  Thus, in addition to what you have stated, you may need to discuss the matter with the company.  

@tax-conundrums

[tax-conundrums]

Thank you George. I also received the following response from Keeper Tax, so shout out to them too!

"Thanks for your patience 🤓 

The stock should be NSO given your contractor status, so if no 1099 was received, you should reach out to the company to verify why it wasn't issued. The 1099-NEC would reflect the difference between the FMV and the exercise price, and it would be treated as ordinary income to you on your 2021 return.

Let me know if any other questions come up 😊

Thanks,

Customer Support
Keeper Tax"

I have now reached out to the company and am requesting clarification and a 1099 from them so I can report this properly on my taxes.