Treating Convertible Notes as Equity for Tax Purposes – The Best of Both Worlds?
Some people continue to debate whether convertible notes are the appropriate method for capitalizing early-stage ventures, and the proponents of convertible notes as well as the detractors each have valid arguments. However, convertible notes have become commonplace for startups, either as an initial financing device or in the context of a true, intermediate “bridge” financing.
For tax purposes, however, convertible notes can introduce complications that don’t typically arise in an equity financing, because the tax rules impose special rules to loan transactions that deviate from the most simple arrangement of immediate and consistent payments of fixed-rate interest.
In the startup context, parties rarely structure for mandatory immediate payments, so the tax rules can impose deemed taxable interest, corresponding reporting obligations, and even taxable “phantom income” in certain situations where the note is not repaid.
Therefore, consider the potential benefit of using a convertible note that the parties agree to treat as equity for tax purposes. In certain situations, the parties may be able to avoid negative tax consequences by formally acknowledging that their convertible note instrument falls on the equity side of the spectrum (for tax purposes). Investors might avoid taxable “deemed interest” payments and could possibly accelerate the starting date for the 5-year holding period required for tax-preferred “qualified small business stock.” Issuers might avoid the responsibility for reporting deemed payments (and Congress recently – and quietly – increased the penalties for failures to report “deemed interest” by 250%). Furthermore, issuers could experience a reduced tax cost if they undergo a future restructuring if they have no debt on their cap table (for tax purposes).
Note: This content is provided solely for general informational purposes. It does not constitute legal advice regarding any specific facts and circumstances, and its dissemination does not create an attorney-client relationship. If you are interested in learning more or want to discuss a particular situation, you should contact one of us, another attorney, or a tax adviser.