Convertible Notes are a common tool amongst early stage tech investors. Notes are a great way for startups to raise early capital without needing to establish a priced equity round. That being said, if you invest in a startup using a Convertible Note either directly or via an SPV you should be aware of differentiated tax treatment from investing in a priced equity round.
Convertible Notes are debt and structured like traditional debt, with a set interest rate and terms. Now these terms are often favorable to the company and involve no repayment on the interest till maturity or conversion of the note into stock and allows the company to pay that interest via additional shares. Sounds pretty harmless, no money is actually being moved or paid so why would that create any tax headaches?
Interest, paid in cash or accrued over a period of time is reported as what is known as OID or original issue discount income. This income, which is a result of the interest must be recorded on a form 1099 OID by the company and then filed as part of the investors tax returns. Investors need to file this form and record that income if they file both on a cash basis or accrual basis.
If you invested via an SPV, the 1099 OID would be issued to the SPV and the SPV would need file taxes and issue K-1's to each investor to properly document the pass through of that income to each partner in the SPV.
While Convertible Notes can make it simpler and easier for founders to raise capital without the burden of needing a priced round but that comes with the added tax filling complexity of the 1099 OID and if using an SPV, K-1's for all partners.
Syndicately can help track and administer the tax returns for your SPVs that invest in Convertible Notes. Learn more today at syndicatley.com or book a demo.