Convertible Note Interest

Tax Consequences of Exercising a Conversion Option on a Note with Accrued Interest

Convertible notes are a popular fundraising tool for startups and emerging companies. These notes are promissory notes that offer investors the option to convert their investment into equity in the company instead of receiving repayment. Typically for startups, investors issue convertible notes with the intent to exercise the conversion option at a later date. However, one aspect that companies and investors might overlook is the tax implications of the accrued interest on these notes.

As a convertible note accrues interest over time, the value of the equity upon conversion includes both the original principal amount and any accumulated interest. From a tax perspective, this means that the holder of the convertible note must report interest income in the year the note converts, even though no cash payment is made.

It’s crucial for companies issuing convertible notes to understand these tax implications and to communicate them clearly to investors. This way, investors won’t be surprised when their accountants inform them of the additional tax on the accrued interest. Companies should also be prepared to issue a 1099-INT form to investors by January 31st of the year following the conversion.