Convertible Note Tax Treatment for Startups & Investors

A convertible note is a form of short-term debt that startups use to raise capital. It acts as a loan that can be converted into company stock at a later date, often during a future funding round. This instrument allows new companies to secure funding without immediately setting a valuation. The tax consequences for the investor and the issuing company depend on events during the note’s lifecycle, such as interest payments, conversion into equity, or cash repayment.

Tax Implications for the Note Holder

For a convertible note holder, the investment journey involves several distinct tax events. The specific tax treatment varies significantly depending on whether the note pays cash interest, converts to stock, or is repaid in cash.

Initial Investment

The purchase of a convertible note is not a taxable event for the investor. It is treated as a loan to the company, establishing the investor’s tax basis in the note. The basis is the original investment amount and serves as the starting point for calculating future gains or losses.

Interest Payments

Convertible notes accrue interest with direct tax consequences. If interest is paid out in cash, those payments are taxed as ordinary income for the investor in the year they are received. More commonly, interest accrues but is not paid in cash and is instead treated as Original Issue Discount (OID). Investors must recognize this accrued interest as taxable income each year, even though no cash is received. This recognized OID income increases the investor’s tax basis in the note.

Conversion into Equity

The conversion of a note into the issuer’s stock is generally not a taxable event, meaning an investor does not recognize a gain or loss at that time. The investor’s tax basis in the original note, including any previously taxed OID, carries over to become the basis in the newly acquired stock. A key detail is that the holding period for the stock begins on the date of conversion, not the date the note was issued. This distinction impacts the calculation for long-term capital gains.

Qualified Small Business Stock (QSBS)

Qualified Small Business Stock (QSBS), under Internal Revenue Code Section 1202, allows investors to potentially exclude capital gains from the sale of eligible stock. An investor may be able to exclude up to 100% of the capital gains, limited to $10 million or 10 times the investment basis. To qualify, the stock must be from a QSB at the time of conversion and held for more than five years.

The five-year holding period for QSBS begins on the date the note is converted into stock, not the date the note was purchased. A convertible note itself is debt and cannot be QSBS. This delayed start to the holding period is an important consideration for investors.

Repayment in Cash

If the startup repays the note in cash at maturity, the transaction is treated as the disposition of a debt instrument. The investor recognizes a capital gain or loss, calculated as the difference between the cash received and their adjusted tax basis in the note. Any final interest payments are taxed separately as ordinary income. The character of the gain or loss depends on how long the note was held.

Tax Implications for the Note Issuer

For the startup, the tax treatment for issuing a note mirrors the investor’s experience. The primary events for the company involve the initial receipt of funds, the handling of interest expense, and the eventual conversion or repayment of the note.

Issuance of the Note

When a startup receives cash for a convertible note, it is not taxable income. The funds are recorded as a liability on the company’s balance sheet, reflecting the obligation to repay the debt or convert it to equity. This transaction does not impact the company’s taxable income at issuance.

Interest Expense

Interest that accrues on a convertible note is a deductible business expense for the issuing company. This includes both interest paid in cash and the non-cash interest that accrues as Original Issue Discount (OID). Deducting this interest expense can reduce the startup’s taxable income.

Conversion into Equity

When a note converts into equity, it is generally not a taxable event for the issuer. The company extinguishes a debt liability and replaces it with equity on its balance sheet. However, a potential issue is Cancellation of Debt Income (CODI). CODI can occur if the fair market value of the stock issued is less than the note’s outstanding principal and accrued interest. This difference could be taxable income, though a company that is insolvent or in bankruptcy may be able to exclude this income.

Repayment in Cash

If the company repays the note with cash, the repayment of the principal is not a taxable event. The company is settling a debt obligation. Any final interest paid at maturity is deductible as an interest expense if it has not already been deducted as it accrued.

Original Issue Discount Explained

Original Issue Discount (OID) is a form of interest that accrues over the life of a debt instrument but is not paid in cash. It is a common feature in startup convertible notes with significant tax implications for both the investor and the company.

What is OID?

OID is generated when a debt instrument is issued for less than its redemption price at maturity. With convertible notes, OID is most often created when interest accrues but is not paid annually. Tax rules treat this deferred interest as OID, which must be accounted for over the note’s term.

How OID Applies to Convertible Notes

The most common scenario creating OID is when a note specifies that interest accrues but is only payable at maturity or conversion. Even if a note is issued at face value, these deferred interest payments create OID. For example, on a $100,000 note with a 5% annual interest rate, the $5,000 of interest that accrues in the first year would be treated as OID. This amount is then allocated and recognized incrementally over the life of the note.

Tax Treatment of OID

Tax rules require both the note holder and the issuer to account for OID as it accrues. The note holder must include their proportional share of the OID as taxable interest income on their tax return each year. This creates “phantom income” for the investor, as they are paying tax on income they have not yet received in cash. Conversely, the issuer can deduct their proportional share of the OID as an interest expense each year, reducing its taxable income.

Tax Reporting Requirements

The IRS has specific forms and requirements for reporting interest income and expenses related to convertible notes. Both the issuing startup and the investor must comply to avoid potential penalties.

Information and Forms for the Issuer

The issuing startup is responsible for tax reporting. The company must track the OID that accrues annually and file Form 1099-OID for each note holder, reporting the OID amount they must include as income. If the note pays cash interest, the company must issue Form 1099-INT. If any accrued interest is paid with stock at conversion, that amount is also taxable to the investor and must be reported.

Information and Forms for the Holder

The investor will receive Form 1099-OID and potentially Form 1099-INT from the issuer. These amounts must be reported as interest income on the investor’s tax return, often on Schedule B of Form 1040. It is the investor’s responsibility to report this income even if the company fails to issue the forms. Investors must also maintain detailed records of their original investment and any recognized OID income to accurately track the note’s tax basis.