[author: Dan Wright]

Many start-up companies use convertible debt as a way to attract short-term investment. Convertible debt has appeal to investors because it can provide enhanced risk protection, while at the same time allowing for participation in the appreciation of the company as the value of the stock increases.  It has appeal for start-up ventures because the cost of issuing convertible debt may be lower, and it can result in access to funding in a shorter time frame than issuing an additional round of equity.

Understanding the federal income tax consequences to the holder and the issuer can be daunting, depending on the complexity of the terms.  For instance, questions arise as to when interest is reportable by the holder and when the issuer (the start-up company) receives interest deductions.  Over the course of the term of the instrument, other questions often arise as well, such as whether or not the lender/investor recognizes gain on conversion, the tax consequences of accrued but unpaid interest at the time of conversion, and how to determine the holder’s basis in stock received on conversion.

I have included below a short list of the most common tax questions I receive related to convertible debt, along with what are intended to be straight-forward answers. To keep the discussion simple, I have assumed that the debt instrument in question contains traditional debt terms, i.e., the instrument has a fixed repayment date, a fixed interest rate, and a stated principal amount.  No principal payments are due on the note until maturity. The only way the note differs from a traditional short-term debt instrument is that it contains an embedded option for repayment with stock of the issuer rather than cash.  I have also assumed that the holder advances to the issuer cash equal to the stated principal amount upon receipt of the note.  Please be aware that instruments that contain more complex or non-traditional terms may result in tax consequences that are different than those discussed below.

Q1 – How is a convertible note characterized for federal income tax purposes (i.e., debt or equity)?

Since a convertible note has both debt and equity features, settling this question is fundamental to determining the tax consequences to both the holder and the issuer. Generally, a convertible note with the terms I describe in the preceding paragraph is considered purely a debt instrument until it is converted. This means that even though the instrument contains an option that has value, the option feature is ignored in the exchange.  As a consequence, the holder of the instrument has no gain associated with receipt of the option feature when cash is exchanged for the note.  For purposes of determining the holder’s basis in the note, the option is ignored.  No bifurcation is required between the debt and the option component of the instrument. 

Contrast this result with a situation where, in addition to the convertible note, the holder receives a separate instrument that entitles to the holder to purchase the issuer’s stock at a favorable price (i.e., a warrant).  Assume no additional consideration is exchanged for the warrant.  The warrant is added to sweeten the deal for the creditor.  Unlike the embedded option, if the separate warrant has value, the investor must treat the transaction as if a note and a warrant are purchased.  Here, the holder must allocate the purchase price and assign a basis to each instrument.  To do this, the cash payment to the issuer must be bifurcated between each instrument based on the relative value of each instrument.

• Example 1
  Assume a lender loans $10,000 under the terms of a convertible debt instrument, and in conjunction with making the loan also receives a warrant allowing for the purchase of additional shares of common stock independent of whether or not the debt is converted.   Also, assume that the warrant has a value at issuance of $400.  (Note that in practice determining the value of the warrant can be challenging.)  For purposes of determining the lender’s basis, the cash advanced and paid to the issuer must be bifurcated, i.e., $9,600 will be allocated to the holder’s basis in the note and $400 to the holder’s basis in warrant.  Because the note will pay $10,000 at maturity, the $400 in excess of the basis of $9,600  will be treated as original issue discount, described below.

Q2 – When must interest be recognized by the creditor/investor?

If the note requires regular payments (at least annually) of interest and if those payments are made timely, then the creditor/investor recognizes the interest income when the interest is paid.   This assumes that the stated interest is at least as high as the published federal interest rate (referred to as the “applicable federal rate” or AFR).  It also assumes that the creditor/investor is a cash basis taxpayer.

Often, the instrument requires that interest accrue on the note, but it is not paid until the note matures.  In this case, creditor/investors may be surprised to receive a 1099 for interest income when they have not received any cash payments.  In this situation, federal tax rules require that, even though the interest is not paid, it is still treated as paid if payments are not made at least annually.  Hence, the issuer must issue Form 1099s to non-corporate creditor/investors. Assuming the creditor/investor actually receives the accrued interest in the form of a cash payment at maturity, the creditor/investor is treated as having basis in the cash payment to the extent the interest has been previously reported. Similar rules apply when the debt instrument does not specify an interest rate or if the interest rate is below the AFR.   In this case, the issuer of the note also receives a tax deduction for any interest that is reported to the creditor/investor in the year it is reported.

• Example 2
  Assume a start-up company issues convertible debt of $10,000.  The annual interest rate is 5% and no payment of interest is required until the note matures.  Even though the company will not be making annual interest payments until maturity, the lender will still receive a 1099 reporting $500 of interest income for years 1-3.  In addition, the company will be able to deduct this amount as interest expense for each of the three years.  Note that in a situation where the note does not require interest (or has a stated rate that is below the AFR discussed above), the note must be carefully analyzed to determine if it is “debt” under federal tax law.   Assuming it is considered debt, the complex “original issue discount” (“OID”) rules apply.   When these rules apply, interest is imputed based on a set of financial math rules contained in the federal regulations.  Again, even though no cash was received, the lender must report interest income.   There may be a Form 1099 filing requirement, and the issuer receives an interest deduction.

When payment of the principal and the interest is due at the end of year 3, the lender will have basis in the payment of interest equal to $1,500, or the amount of previously reported interest income, so no additional income is triggered by the payments.

Q3 – What if stock received upon conversion of the note has a value higher than the principal amount of the note?

The IRS has issued a ruling indicating that no gain is recognized when the note is converted into stock ownership.  The basis of the stock is equal to the holder’s basis in the note immediately before conversion.   The holding period of the stock begins at the time the debt was issued.  No gain is recognized by the issuer of the note on conversion.

Q4 – What if there is accrued (but unpaid) interest on the note at the time of conversion, and rather than receive a cash interest payment, the lender receives additional shares?

The lender still must report that accrued interest as if cash were paid at the time of conversion.   The rules treat the transaction as if cash were paid to the lender and then the lender immediately purchased the additional shares.  The issuer must issue a Form 1099 to non-corporate lenders, and is allowed a corresponding deduction for the accrued interest settled with the stock payment.

• Example 3
  Assume the lender in Q2 converts the note to stock on June 30^th of year 3.  At that point  $250 of interest has accrued during year 3, and the issuer issues additional shares of stock for all of the accrued, but unpaid interest of $1,250 ( i.e., $500 for each of years 1 and 2 (which have already been included in income), and $250 for the first half of year 3).  The lender will receive a 1099 for year 3 reporting $250 of interest income, and the company will have a $250 deduction for interest.  The lender will have basis in the shares received of $11,250 ($10,000 for the amount initially advanced to the issuer, and $1,250 for the interest income reported in years 1-3).

While the above discussion addresses the tax issues associated with a basic convertible debt instrument, many convertible notes reflect far more complex features.  Notes with a wide variety of terms are commonly used in today’s marketplace.  The actual tax results associated with more complex instruments can vary significantly, depending on the actual terms of the instrument.  Sometimes these instruments call for contingent cash payments during the term of the debt, and often warrants are issued alongside the debt instrument.  Premiums and discount rules may also apply.   All of these variations can affect the amount, timing and character of income associated with the transaction. If you are considering an investment in the form of a convertible debt instrument, you should discuss the exact terms of the transaction with your tax adviser before committing yourself to the investment.

Dan Wright is a Principal CPA and a tax consultant with Clark Nuber P.S. in Bellevue where his practice focuses on serving emerging businesses. His areas of expertise include federal and state taxation of technology companies, executive compensation arrangements, choice of business entity issues, and business buy/sell/combination transactions. Dan holds a Master’s in Taxation degree from Brigham Young University. He enjoys hiking, biking and playing blues guitar.

*Please note that the views and opinions expressed in this guest blog post are not necessarily that of Davis Wright Tremaine and Joe Wallin.