So, you started a business and you issued a convertible note. You know, a loan that can be repaid with the equity of your start-up.
The date of the note conversion has arrived and you’re busy calculating how many shares you need to issue when suddenly you get an email from the investor (lender). “My CPA told me that this conversion may be taxable. Is that true?”
There’s good news and bad news. The good news is that the conversion of the principal does not cause tax. The bad news is that the conversion of the accrued interest does.
Conversion aside, taxable interest should have been reported annually by the company to the lender on a Form 1099-INT or a Form 1099-OID over the life of the loan. This is true even if no interest has been paid because at a minimum you have to report imputed (phantom) interest. The reported interest causes tax to the lender and creates a deduction for the company.
Founders often fail to report this interest, probably because they simply aren’t aware they need to do so.
At the time of the conversion, any accrued interest that converts into equity and hasn’t already been taxed is taxable.
It’s worth mentioning that the above result only occurs if the note is debt for tax purposes. If the note is equity for tax purposes, the conversion can be completely tax free and there is no annual interest reporting.
How do you determine whether a note is debt or equity? I’ll explain in a future post. But check the note to see if it includes language stating that the parties intend to treat it as equity for tax purposes. While such language isn’t binding on the IRS, it is a good fact.
Mike Baker frequently advises with respect to convertible notes. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.