What happens to an employee's stock options when he converts to consultant status ?

ISO plans typically spell out employment status requirements and provide for what happens at termination of employment. Your former employee has terminated employment and become a consutant. Your plan document should address this. This person's status as a consultant is subject to question under IRS rules.

ISOs can only offer their preferential tax treatment (no tax at exercise, only later, at disposition) to employees. So 3 months after the individual stops being an employee, the preferential tax treatment also ends. However, if the terms of the plan allow it (check the language to see if the language is "continuation of service" or "employment"), the option may continue and simply be treated as a non-qualified stock option (spread at exercise taxed as ordinary income). Even if the grant agreement/plan does specify that option should be cancelled at the time that employment ends, you can modify the option to change that condition.

Remember that accounting for non-employee options under FAS 123(R) / ASC 718 is very different than accounting for employee options - the fair value is not "set" until the vest date and must be remeasured each quarter until the vest occurs AND if you modify the grant, you may need to apply modification accounting to account for the change.

If the ISO is modified (say extended), if becomes a NSO. The re-characterization to NSO will result in W-2 income (upon exercise) and employment taxes (both employer and employee). At least that's my experience, your situation may vary.

Although Elizabeth's answer is correct, please be aware that you must modify the twrms of the option prior to the change in status and it should be done at a board meeting or by resoultion. Most plans do not allow retroactive changes to the terms of the grant. If you are contemplating a change in status contact your sticl paln administrator prior to your change.