Convertible Notes Past Maturity: Extend, Convert or Forgive

What happens when a convertible note matures with no priced round?

Nothing is taxed just because the maturity date passes. Missing the payment is not a change to the note. Neither is holders holding off on collection with no other change to the terms, unless that lasts more than two years after the missed payment, plus any time spent negotiating in good faith or in bankruptcy (regulation 1.1001-3(c)(4)). The note stays debt, and interest keeps accruing under its terms. Tax follows what holders and the company do next.

A case needs a closer look when holders also change the rate, cap or discount, when stock issued is worth less than the debt, when outside holders forgive, or when the company is near insolvency. Each of those can create income for the company or holders.

Gather the note agreements and every amendment, a schedule of accrued interest by holder, the cap table showing which holders own stock, the company's accounting method, and a balance sheet at fair market value on the date of any forgiveness.

Is a convertible note maturity extension a taxable change?

A maturity extension is usually not taxable when it stays inside the safe harbor in Treasury regulation 1.1001-3. A change to a note is treated as an exchange of the old note for a new one only if it is a "significant modification."

Delaying a payment is significant only if it is a "material deferral." The safe-harbor period starts on the original due date and runs for the lesser of five years or 50% of the note's original term. A deferral is not material if every deferred payment is unconditionally payable by the end of that period.

Past the safe harbor, the regulation weighs all the facts: the length of the deferral, the original term and the amounts deferred. Three traps:

• Extensions add up. A series of extensions is tested as if made at once.
• The original term ignores extension options. A note that already let holders extend is measured on its original maturity.
• A weaker company does not, by itself, make the new note equity. The regulation disregards decline in the issuer's finances since issue when testing whether the modified note is still debt.

What if the extension also changes the interest rate or the cap?

A rate change is significant if the note's yield moves by more than the greater of 25 basis points or 5% of the old annual yield (1.1001-3(e)(2)). An extension that also changes the yield is tested under both the timing rule and the yield rule.

A change to the valuation cap or discount has no bright-line test. It is judged under the general rule: whether the rights altered, and how much, are economically significant. Treat a lower cap or a bigger discount as a judgment call.

If a change is significant, the old note is treated as exchanged for a new one:

• The company compares the new note's issue price with what it owed on the old note. A shortfall is cancellation of debt income (section 108(e)(10); regulation 1.61-12(c)).
• Holders may recognize gain or loss, unless the exchange qualifies as a tax-free exchange of securities in a recapitalization (section 354). Whether a startup note counts as a "security" depends on its facts.

What happens to convertible note accrued interest that was never paid?

Unpaid interest does not disappear for tax. It matters on both sides, and again if the note converts or is forgiven.

• Holders. A note that pays no interest before maturity is presumed issued at a discount. Holders generally include that original issue discount (OID) in income as it accrues, whether or not they are paid and whatever their accounting method (Publication 550). Notes due in one year or less are an exception.
• The company generally deducts OID as it accrues, whatever its accounting method (section 163(e)). The exception is a cash-method company on notes due within one year of issue: it deducts only when it pays (section 163(e)(2)(C)). Interest that is not OID is deducted as it accrues by an accrual-method company and when paid by a cash-method company. If a cash-method holder owns, directly or indirectly, more than half the company's stock by value, even an accrual-method company waits until it pays that holder (section 267(a)(2)). Limits on the deduction, including for automatic conversion, are covered in SAFEs and convertible notes; OID mechanics are in venture debt and warrants.
• On conversion, stock received for accrued interest is treated as interest, not as part of a tax-free exchange (section 354(a)(2)(B)).
• On forgiveness, a company has no income to the extent paying the interest would have been deductible (section 108(e)(2)). That protects only interest the company has not yet deducted. Interest already deducted, as accrued interest or OID, is generally income when forgiven, unless an exclusion applies (Publication 4681).

Is converting a note at maturity taxable to the company or the holders?

Converting under a conversion right in the note's own terms is generally not taxable to holders on principal (Publication 550). The conversion is not even a "modification" of the note when a holder exercises an option in its terms to convert into the issuer's stock (1.1001-3(c)).

The company is treated as retiring the note for the value of the stock it issues (section 108(e)(8); regulation 1.61-12(c)(2)). If that stock is worth at least what is owed, there is no cancellation of debt income.

Two things change this:

• The notes had no maturity conversion right. If holders and the company amend the notes to allow conversion at the cap, the amendment itself is a change to the note. The conversion is then not under the original terms, and the holders' side depends on the exchange rules above.
• The stock is worth less than the debt. See the next section.

What if the stock is worth less than the note when it converts?

The company may have cancellation of debt income equal to the gap. Section 108(e)(8) treats a corporation that transfers stock in satisfaction of its debt as paying the stock's fair market value, and regulation 1.61-12 counts a conversion as a repurchase.

Treat this as unsettled when the conversion follows the note's original terms. Read literally, both reach that conversion: neither has a separate rule for a conversion privilege agreed at issue. The result turns on facts: the cap, the stock's value on conversion date and how much accrued interest converts. A company that is insolvent at the time may exclude the income (see outside holders below). Get a valuation of the stock on the conversion date before deciding how to report.

Convertible note forgiveness: is it income when a shareholder forgives?

A shareholder who forgives a note is treated as contributing it to capital, but only up to the shareholder's adjusted basis in the note. The company is treated as paying off the note with money equal to that basis (section 108(e)(6); regulation 1.61-12(a)).

• Principal the holder paid in cash is basis, so forgiving it is generally a capital contribution, not income.
• Accrued interest is basis only if the holder included it in income. Interest the company deducted but the holder never reported has no basis behind it. Forgiving it is cancellation of debt income to the company unless the company never deducted it, or an exclusion applies.

A note holder who owns no stock is an outside holder for this rule. A holder's own loss on a note that is never repaid is covered in deducting losses in a failed startup.

What if outside holders forgive the notes: insolvency, loss carryforwards and Form 982?

Forgiveness by a holder who is not a shareholder is generally cancellation of debt income to the company. Two exclusions can apply to a startup: a discharge in a bankruptcy (title 11) case, and a discharge while insolvent (section 108(a)).

• Insolvency means liabilities exceed the fair market value of assets, measured immediately before the discharge. The exclusion is capped at the amount of insolvency. Value counts, not book cost.
• The price is your tax attributes. Excluded income reduces net operating losses first, then general business credit carryovers, the minimum tax credit, capital loss carryovers and property basis, in that order, then any remaining carryovers. Credit carryovers shrink by one-third of a dollar for each dollar excluded. The reduction happens after tax for the year of the discharge is figured. How smaller loss carryforwards affect later years is covered in net operating losses for startups.
• Form 982 goes with the company's Form 1120. Check line 1b for insolvency, enter the excluded amount on line 2, and show the reductions in Part II, starting with line 6 for net operating losses (Form 982; instructions). To protect the losses, the company can instead elect to reduce the basis of depreciable property first (line 5, section 108(b)(5)). The election goes on a timely filed return, including extensions, and can be revoked only with IRS consent.

If the company is closing, see returning cash to investors when a startup closes.

Do we send note holders a Form 1099-C?

No. Form 1099-C is filed by the creditor, not by the company that owed the debt. The IRS instructions require it only from listed lenders: banks and other financial institutions, credit unions, federal agencies, and organizations whose significant trade or business is lending money.

An individual angel generally is not on that list, so the company may never receive a 1099-C. It still reports any cancellation of debt income on its own return. Information returns for interest paid to holders are covered in SAFEs and convertible notes.

Example

These examples are illustrative; figures are in US dollars.

Two-year notes extended one year

A company issued two-year notes. At maturity, holders sign an amendment moving the maturity date out one year. The rate, cap and discount do not change. The safe-harbor period is the lesser of five years or half of the two-year term: one year. The deferred payment is due by the end of that year, so the extension is not a material deferral and no new note is deemed issued. An 18-month extension would fall outside the safe harbor and be judged on all the facts.

$1,000,000 of notes plus $80,000 of interest convert at the cap

Holders of two-year notes convert $1,000,000 of principal and $80,000 of accrued interest into common stock at the cap, under a maturity conversion right in the notes. The notes paid no interest before maturity, so the $80,000 is OID. The common stock received is worth $1,080,000.

• Holders: no gain or loss on the principal. The stock received for the $80,000 is interest income, to the extent they have not already included it as original issue discount.
• Company: it deducted the $80,000 as OID as it accrued, so there is no further deduction at conversion. Because the stock is worth what was owed, it has no cancellation of debt income.

A shareholder forgives a $200,000 note and $30,000 of interest

A founder who owns 30% of the stock lent $200,000 in cash on a one-year note at 10% simple interest. The note went unpaid, and 18 months after issue $30,000 of interest had accrued. The accrual-method company deducted it as it accrued. As a cash-method individual holding a note due within a year, she reports the interest only when paid, so she has not reported it. She forgives everything.

• Principal: her basis is $200,000, so that part is a capital contribution.
• Interest: she has no basis in the $30,000, so the company has $30,000 of cancellation of debt income unless an exclusion applies. If the company was insolvent by $50,000 immediately before, it can exclude the $30,000 on Form 982 and, with at least $30,000 of net operating losses, reduce them by $30,000.

Different for you?

• A priced round converts the notes, or you are asking whether note interest is deductible: see SAFEs and convertible notes.
• The conversion is part of a down round or recapitalization: see down round and recapitalization tax.
• The company is winding down and paying holders what it can: see returning cash to investors when a startup closes.
• You are a holder writing off a note that will never be paid: see deducting losses in a failed startup.
• Excluded debt income cut your loss carryforwards, or a conversion may trigger an ownership change: see net operating losses for startups.
• A holder is abroad: stock issued for accrued interest at conversion can need withholding; see SAFEs and convertible notes.
• The debt is a term loan with warrants: see venture debt and warrants.
• Holders are changing the rate or cap, converting stock worth less than the debt, or outside holders are forgiving while the company may be insolvent: each turns on valuation and judgment; get startup tax help before signing the amendment.