Venture Debt With Warrants: Books, OID and the Tax Return

How is venture debt with warrants taxed for the company?

The company deducts what the loan really costs it, spread over the loan's life. Part of the cash the lender advances pays for the warrants, so the loan starts at less than the amount the company must repay. That gap is original issue discount (OID), which the company deducts as interest over the term (26 U.S.C. 163(e); Reg. 1.163-7). Issuing the warrants, and the lender later exercising them, is not income to the company (26 U.S.C. 1032).

What makes a case not simple: a warrant valuation the company and the lender do not share, warrants classed as a liability in the books, a term over five years, a fee due only on a sale or other contingency (the contingent payment debt rules may apply), a loss year that runs into the business interest limit, a prepayment or refinancing, or a foreign lender.

What to gather: the loan and security agreement, the warrant agreement, every fee invoice and the funds flow at closing, the warrant valuation, and the loan's payment schedule.

Why are the loan and the warrants split, and how is the price divided?

The tax law treats a loan and warrants issued together as an investment unit and divides the price between them. The amount the lender pays for the whole unit is allocated between the loan and the warrants by their relative fair market values (26 U.S.C. 1273(c)(2); Reg. 1.1273-2(h)). The part allocated to the loan is its issue price.

The company's allocation binds the lender unless the lender discloses a different one on its own return (Reg. 1.1273-2(h)(2)). The company must give the lender that information in a reasonable manner (Reg. 1.1275-2(e)). A written valuation of the warrants at closing supports the split.

The book split can differ from the tax split. Accounting rules may value liability warrants first and give the loan the rest, while the tax rule uses relative fair market values. Track the two numbers separately.

What is OID on a loan with warrants, and how is it deducted?

OID is the excess of the loan's stated redemption price at maturity over its issue price (26 U.S.C. 1273(a)). The stated redemption price is every payment the loan requires except qualified stated interest: interest unconditionally payable in cash at least annually at a single fixed rate (Reg. 1.1273-1(b) and (c)). A floating rate tied to an index can still qualify under the variable rate rules (Reg. 1.1275-5). The IRS OID guide calls OID a form of interest.

The company deducts OID each year using the constant yield method: the loan's yield to maturity is applied to its growing balance, so the yearly OID deduction rises over the term (Reg. 1.163-7(a)). The deduction does not wait for the final payment.

OID is de minimis when it is less than 0.25% of the stated redemption price times the complete years to maturity (26 U.S.C. 1273(a)(3)). The company still deducts it, but may instead choose to do so at maturity, straight-line, or in proportion to stated interest, choosing by how it reports on the first year's return (Reg. 1.163-7(b)). Run the test on the total OID, including fees and costs, rather than assume either way.

For a term over five years, also test the high yield obligation rules, which can defer or deny part of the OID deduction for a corporation (26 U.S.C. 163(e)(5) and (i)).

How are upfront fees, legal costs and an end-of-term fee treated?

None of them is deducted all at once, unless total OID is de minimis. Each is spread over the loan's term, in one of three ways.

Costs that facilitate the warrants themselves are capitalized under the same regulation, but they are not debt issuance costs, so they are not deducted over the loan term. When one legal bill covers both the loan and the warrants, the split is a judgment call to make with your preparer.

Is venture debt interest limited by section 163(j) and Form 8990?

It can be. Stated interest, OID and repurchase premium all count as interest for the business interest limit (Reg. 1.163(j)-1(b)(22)). That list does not name the company's own debt issuance costs; confirm their treatment with your preparer. The yearly deduction is capped at business interest income plus 30% of adjusted taxable income, and the excess carries forward to later years (Form 8990 instructions).

A small business taxpayer is not subject to the limit and generally does not file Form 8990. For tax years beginning in the page's tax year, that means average annual gross receipts over the 3 prior tax years of $32,000,000 or less, and not being a tax shelter (Form 8990 instructions). Related companies' receipts may be combined. A pre-revenue startup has little or no gross receipts; a fast-growing one should test each year.

Above the threshold, a loss year matters: adjusted taxable income can be small or zero, so most of the interest may carry forward. For tax years beginning after 2024, adjusted taxable income is figured before depreciation and amortization again, which helps hardware-heavy companies (Form 8990 instructions).

Does the company have income when the warrants are issued or exercised?

No. A corporation recognizes no gain or loss on the lapse or acquisition of an option to buy its own stock, and none on receiving money for its stock (26 U.S.C. 1032(a)). That covers issuing the warrants, an exercise for cash or a net exercise, and warrants that expire unused.

Exercise does not change the loan's OID schedule. The split was fixed when the unit was issued.

If the books carry the warrants as a liability and record fair value changes each period, those gains and losses have no tax effect. They are a book-to-tax difference on Schedule M-1 or M-3 of Form 1120.

Venture debt journal entries: how do we book the loan, the warrants and the fees each month?

The books record the loan net of the warrant value and the costs, then build it back up to face value through interest expense. Whether the warrants sit in equity or in liabilities depends on their terms; that classification, and the method of spreading the discount, are calls to settle with your auditor.

Keep a separate tax schedule of issue price, OID and yearly deductions; the book discount schedule often differs. For covenant reporting and the board package, see monthly financials for investors and the board.

Do we send the lender a Form 1099-INT or 1099-OID?

Only if the lender is not an exempt recipient. A corporation, a tax-exempt organization and certain dealers are exempt, so no form is filed for them (Form 1099-INT and 1099-OID instructions). A lender organized as a fund partnership or LLC is not on that list by default, so collect a Form W-9 at closing and read its classification.

For a non-exempt lender, the company files Form 1099-INT for interest on debt issued in registered form of $10 or more, and Form 1099-OID when the year's OID for that holder is $10 or more. Both stated interest and OID may go on one Form 1099-OID (instructions). Other interest paid in the course of a trade or business has a higher threshold; check the current instructions. Whether the loan is in registered form depends on the agreement, usually whether it keeps a register of lenders. A foreign lender is reported on Form 1042-S instead, and interest and OID paid to it face 30% withholding unless an exemption documented on its Form W-8 applies. The portfolio interest exemption fails for a lender with 10% or more of the voting power, counting its warrants as owned stock (26 U.S.C. 871(h)(3)). Withholding the company misses is tax it owes itself (26 U.S.C. 1461); see foreign investors in a startup round.

What if the loan is prepaid or refinanced?

Prepaying generally lets the company deduct the unamortized cost in the year it pays off the loan. When the company repurchases its debt for more than its adjusted issue price (issue price plus OID already deducted, minus principal and other payments besides stated interest), the excess, called repurchase premium, is deductible as interest that year (Reg. 1.163-7(c)). Remaining warrant value, fees and any prepayment penalty land there.

A refinancing with a new lender works the same way for the old loan, and the new loan's costs start their own schedule. Amending the existing loan is different: a significant modification is treated as exchanging the old loan for a new one (Reg. 1.1001-3). In a debt-for-debt exchange where neither loan is publicly traded, repurchase premium is spread over the new loan's term instead of deducted at once (Reg. 1.163-7(c)). Get advice before signing an amendment that changes the rate, term or payments.

Example

Round, illustrative numbers in US dollars. Each loan is interest-only, with interest paid at a fixed rate and the principal due at the end.

$5,000,000 term loan with warrants

A startup borrows $5,000,000 for four years at 10% and gives the lender warrants valued at $150,000. The loan alone is worth $4,850,000, so the relative-value split gives the loan an issue price of $4,850,000 and OID of $150,000. The de minimis line is $50,000 (0.25% × $5,000,000 × 4), so the OID is not de minimis.

The company's gross receipts are under the small business threshold and it is not a tax shelter, so the business interest limit does not apply.

$50,000 end-of-term fee

Same loan, plus a $50,000 fee due at maturity. The stated redemption price becomes $5,050,000, so OID is $200,000 ($150,000 warrants plus $50,000 fee). The company deducts the fee through the OID schedule over the four years, not in year four when it pays it.

Lender exercises warrants at Series B

In year three the lender exercises, paying $150,000 to buy preferred shares worth $500,000. The company issues the shares and records the cash in equity. It has no gain or income, and its OID schedule continues unchanged.

Different for you?

• You raised on SAFEs or convertible notes, not a term loan: see SAFEs and convertible notes.
• Interest, OID and other deductions leave a loss: see net operating losses for startups.
• Investors ask whether the loan cash affects QSBS: see the QSBS gross assets test.
• Notes matured unpaid and are being extended or converted: see convertible notes past maturity.
• The lender reports covenants from your monthly books: see monthly financials for investors and the board.
• Warrants are classed as liabilities, the term exceeds five years, you are prepaying, or receipts are near the interest-limit threshold: these need a tax schedule built from the documents; get startup tax and accounting help.