In this episode of How Tax Works, host Matt Foreman discusses the tax consequences of Convertible Debt and Simple Agreements for Future Equity (SAFE).  From explaining what it means to use Convertible Debt and SAFEs, to the tax consequences of each, this episode is for anyone who is investing in a business in anything that is not strictly equity or debt.

Please also see Matt Foreman’s upcoming webinars! Links are below:

• Positives and Negatives of S Corporations
  October 29th, 2024 @ 1:00pm – 2:00pm EDT 
• Tax Strategies for Limited Partner Investors in Private Investment Funds
  November 14th, 2024 @ 1:00pm – 2:30pm EST

Listen to the episode here:

  

Follow us on Twitter: @HowTaxWorks

How Tax Works, hosted by FRB Partner Matthew E. Foreman, Esq., LL.M., delves into the intricacies of taxation, breaking down complex concepts for a clearer understanding of how tax laws impact your financial decisions. Through this, listeners are treated to a comprehensive breakdown of entity structures, from the robust shield of C corporations to the flexibility of partnerships and LLCs. Foreman navigates through the maze of tax considerations, shedding light on entity-level taxation, shareholder responsibilities, and nuanced tax strategies. Foreman shares valuable insights and practical advice, emphasizing the need for informed decision-making and consultation with tax professionals. From qualified small business stock to state and local tax considerations, no stone is left unturned in this illuminating exploration of tax law and entity selection.

Whether you’re a seasoned entrepreneur, accountant, lawyer, or financial advisor, “How Tax Works” offers a wealth of knowledge to empower you in making sound business decisions. Tune in and embark on a journey to unravel the complexities of tax law, one episode at a time.

This podcast may be considered attorney advertising. This podcast is not presented for purposes of legal advice or for providing a legal opinion. Before any of the presenting attorneys can provide legal advice to any person or entity, and before an attorney-client relationship is formed, that attorney must have a signed fee agreement with a client setting forth the firm’s scope of representation and the fees that will be charged.

Transcript:

**This transcript has been prepared automatically by AI and may contain inaccuracies**

Matthew Foreman [00:00:00]:
Welcome to the 8th episode of How Tax Works. I’m Matt Foreman. In this episode, I’ll discuss convertible debt and simple Agreements for Future equity, commonly known by their acronym safes. How Tax Works is meant for informational and entertainment purposes only. This may be attorney advertising, and it is not legal advice. Please hire your own attorney. How Tax Works is intended to help listeners navigate the intricacies and complexities of tax law, regulations, case law, and guidance to demystify how taxes shape the financial and business choices that we all make.

Matthew Foreman [00:00:42]:
Before I get started, a few Administrative Things episodes every two weeks. There’ll be one in a couple weeks. It’ll be on a Wednesday or on a Tuesday. Trying to avoid holidays. Mondays tend to have a lot of holidays this time of fall, so that’ll be it. The next episode is just a couple Common State and local income tax issues State local issues are, you know, often quirkier. They pop up in different ways and they tend to be more complex because, you know, most tax professionals focus on federal issues. They’re just the bigger dollars.

Matthew Foreman [00:01:11]:
They’re more common. And state and local issues kind of have their own quirks. And so I thought it would be a good episode to do. Not entirely sure how it’s going to be laid out, but we’ll see how that goes. If you have any questions, comments, or constructive criticism, you can email me at my FRB email address, which you can find via your favorite search engine. Have a couple upcoming webinars and presentations that you can attend. There will be links for both of these on the main FB page for How Tax Works, you’ll see the link I post on LinkedIn. Things like that.

Matthew Foreman [00:01:40]:
October 29th there’s a free webinar. There’s CLE for New York, and obviously a lot of states have reciprocity CPE for CPAs and CE for EAs. It’s on S Corporations. If you’ve listened to this podcast before, or you know me at all, you may know that I’m not a fan of S Corporations for a variety of reasons. Some real, some imagined. I’ll be talking about that for an hour. It’s free and you’ll get continuing ed unless you’re a doctor, very unlikely to qualify for that. And then on November 14th doing something with Stafford Strafford, Stafford, I don’t know.

Matthew Foreman [00:02:12]:
But anyway, there’ll be a link. I’m sure they love that I’m mispronouncing the name Tax Strategies for Limited Partner Investors in Private Investment Funds. It’s Stratford Strafford Not Stafford, that’s the quarterback for the Rams who used to play for the Detroit Lions. Anyway, both the October 29th and the November 14th are at 1:00 clock Eastern. So again links on the How Tax Work episode page on the FRB website. So you know, sign up. Hopefully you enjoy it. The Stratford one does have a price.

Matthew Foreman [00:02:39]:
I don’t know what it is but you know, hopefully it’s worth your time and I think it will be that one. The October 29th is an hour. The one on November 14th is 80 minutes. I suspect we’ll go along. There’s a lot of material where they’re working together with a colleague of mine, Mike Williams from the Corporate and Securities Group because you really can’t totally talk about tax stuff without talking about like what things are and other issues that sort of run into it because tax tends to hem in and change how corporate deals are done between structuring focused on tax for the most part anyway. So what you came to hear about, hear me talk about today is convertible debt and safes. The first question I always get, I’m going to start with convertible debt, then go to safes, then kind of talk about them together, right. Is what is convertible debt has nothing to do with the Corvette or any vehicles.

Matthew Foreman [00:03:26]:
It’s a debt instrument that gives the holder the right to convert it into equity of the issuer. So right. The recipient of the current debt can use it to take the debt and the debt will become equity in the company. In the business people say, oh, you can only do it in corporate now you can do it in any entity whatsoever. Theoretically, I suppose you could do it. You could have convertible debt in a disregarded entity, in a sole proprietorship with no entity, then upon the grant it will become a partnership by general partnership. So you don’t even need an entity. Although I suspect if you’re doing convertible debt, you probably have an entity.

Matthew Foreman [00:03:59]:
You taking that little minimal step. So I think it’s important to do, you can do in a variety of ways. Sometimes it’s the stated number of shares, sometimes it’s a fair market value of equity. For example, you know it could be 500 shares, 500 units of an LLC, it could be $800 worth of equity, whatever you want it to be. A few things I always point out one convertible debt, it doesn’t need to pay interest. It can have what’s called original issue discount. But you he probably a lot of times pays interest over time it accrues. People always ask me well when does it convert? And the answer is make up whatever you want.

Matthew Foreman [00:04:33]:
There are no rules. For the most part, you can make whatever you want. You can make it based on, you know, if there’s a triggering event, if there is sales go over a certain threshold, it can convert in three years. It can be a pure option, right? You can just say, look, can’t convert for two years, but after two years you can convert at any time. This is the ratio for how it works. This is the mechanism, you know, know, build in a notice requirement, etc. Etc. So it can really be anything you want it to be.

Matthew Foreman [00:04:59]:
Convertible. That’s extremely flexible. Conversion is not a taxable event. I should note, you know, from a cottage savings, I talk about the case a lot and section 1001. Generally speaking, if you were to exchange debt for equity, that would be taxable as if you, you know, basically were paid for the debt and then use it to purchase equity. But under there’s A Treasury Regulation 1001 1, 1.10013 C2 Roman at 2 and Revenue Ruling 72 265, they talk about, I’m not going to do a lot of citations here, don’t worry. Basically they give an exception. The conversion from debt to equity is not a taxable event.

Matthew Foreman [00:05:34]:
Okay? So a lot of times if you were to do this and make it taxable, if this was not convertible debt, you said debt and you said, well, we just want to convert it into equity, what would happen is the interest portion would need to be recognized or in some way dealt with from a tax perspective. As long as the debt itself, okay, is from the beginning convertible debt, that’s when that treasury regulation, the revenue rule, and kick it, then you’re fine. A lot of people want to do it later. Can’t. And if you were to exchange debt for debt, right, Theoretically you can do it. This is what cottage savings is about. Loan pools for loan pools. But adding in the convertible debt feature is probably sufficiently different that exchanging non convertible debt for convertible debt is probably a taxable event in and of itself.

Matthew Foreman [00:06:16]:
Again, interest is recognized, could have cancellation deadness, income issues and things like that. So watch out for that. What I always say to people is if you have debt, you think you might want to make it convertible at some point, but you probably don’t. What people do a lot of times is they’ll make the conversion in four years and a month before they give the issuer the option to just pay it all off, basically, you know, prevent it from converting. And that’s what a lot of people do. Anyway, so upon conversion, talking about tax here, the basis in the stock is equal to your basis in the convertible debt. So it’s not. Doesn’t include any interest that it could have accrued or anything like that.

Matthew Foreman [00:06:51]:
If you, you know, hundred dollars was the loan for the convertible debt, your basis is now $100. Fair market value can be whatever it is at that point. No taxable consequences upon conversion. One really kind of common but clunky issue I run into is your debt really debt? There’s a lot of stuff under section 385, the internal revenue Code only technically deals with C corporations, I guess, and as corporations too. But what it is is you get these debt issuances that have a lot of equity features in it. And people always say, well, how could debt be equity? But what I’ve learned in practicing now for almost 20 years is that people want to get the upside of the business, but they want to be a note holder. They want to be a debt holder because you get better creditor rights, right? So you get these debt things that have, you know, super subordinated to other debt. It has voting rights, it only gets interest if dividends or distributions are paid and things like that.

Matthew Foreman [00:07:46]:
And that can be considered equity for tax purposes, right? I’m not talking about debt or credit or rights, bankruptcy, anything like that, only tax. And so you sort of have to think to yourself, well, you know, what are we issuing and is it really equity? So I’ve seen convertible debt that gets distributions. I see uncoverable debt that has upside with the business and that can get really kind of iffy. And so you run into this situation, you know, maybe the convertible debt, you do have to pay interest. The interest may not be deductible simply because instead of deducting the interest, right. Or instead of being able to duck interest, well, it’s equity and payments of equity not deductible. Distributions on equity are not deductible. So that’s kind of an issue you have to run into.

Matthew Foreman [00:08:26]:
Just making sure. I always think about, you know, another important one is holding period, right? What is a holding period? Long term capital gain, short term capital gain, Things like that can be really important. Right. Right now capital gain rates are 20% plus, you know, perhaps the net investment income tax rate 23.8 and short term is 37. Right. So that’s a big delta, about 13%. So it’s a question of whether the holding period upon conversion is when the debt is issued or when it converts. And for general purposes of selling the stock, the holding period.

Matthew Foreman [00:08:56]:
Okay. For the upon conversion. Right. Is when the debt is issued. So if on 112022 you issue the debt and on 11 2024. Right. It converts. If you were to sell it today, then I’m recording it.

Matthew Foreman [00:09:11]:
I don’t think this will be released for another week or so. But let’s say you sell it. Oh, do it on the release day. Right. On the 16th and on the 16th of September and what’s going to happen? You sell it. Then it is long term capital gain. Right. Assuming that the asset is a capital asset.

Matthew Foreman [00:09:27]:
Not going to totally get into that. Talk about that. More safes but I’m just sort of assuming it’s a capital asset. If you’re a dealer or trader in equities or things like that that may mess with it might be ordinary income. But we’re just sort of making an assumption here. Know what happens when you assume. But that’s the idea, right. It’s upon conversion.

Matthew Foreman [00:09:44]:
There is a distinction to that. Under section 1202 of the Internal Revenue Code anyone who is ever deals with qualified small business stock, the holding period for 1202 purposes is upon conversion. The premise is under 1202. I think it’s F. And what it says is if you get QSBS stock because you gave up one class of stock and received another, that’s the same premise. If you had convertible debt, it converts to equity. Same basic premise that we are dealing with here. So you really have to think through what is the holding period.

Matthew Foreman [00:10:15]:
It can be different for different purposes and, and that’s really important for convertible debt. Understanding what the tax implications are then there are also issues with original issue discount. I’m not going to discuss here. I’m not really going to explain what it is. But it deals with times when the interest, you know, you buy it for one value and the interest just never gets paid. Right. That’s an original issue discount. There are other issues that deal with it.

Matthew Foreman [00:10:37]:
I’m just not going to go in there because frankly I would need to spend about 10 or 15 minutes to go through them and I would just rather kind of skip that part of it. I don’t think it’s relevant. It’s a minor, minor one. I also point out on convertible debt it’s important to make sure the interest rate is at least AFR the applicable federal rate. By making sure that the rate is at least the afr. You’re not going to get imputed income and other issues that may deal with that. If you don’t know What AFR is that? I recommend googling it applicable federal rate. You know, there’s, there’s explainers the IRS has what you have to do, what the rate is, things like that.

Matthew Foreman [00:11:12]:
Identify. Quick break. Be back in a moment. Okay, so now we’re moving on to simple agreements for future equity. Safe. It’s spelled with only one F S A F E. You know, it’s a, probably a technically a backronym where you come up with what you want the acronym to be and then you sort of back into it. A lot of famous ones if you look into it.

Matthew Foreman [00:11:39]:
But, but anyway, so the question I get a lot, and this is really not a tax question, but what is a safe, right? From a just a general economic perspective, what is one? And what happened was in 2013, Y Combinator, sort of the best known incubator in the world, it created what was called the safe. And they existed before, but they were, you know, kind of minor and they weren’t well done. And there was a lot of flavors of it. And Y Combinator kind of looked out there and said, well, this is what we want to do, so we’re just going to do it. You know, when you’re that big, you can kind of do things like that. And what they did is they created something that never really existed before. If you want to read about the background, what things are on the Y Combinator website, they have a user guide and a quick start guide. Highly recommend you read them just to get context for it.

Matthew Foreman [00:12:28]:
Explains a lot of the terminology, some of which I’ll discuss here, some of which I won’t. They released one in 2013, now there’s four in 2018 for some common changes. And now you’re going to see a lot of changes on changes on changes. Sometimes you get ones that are straight vanilla. They’re really just. They fill in the blanks. And some have some real material changes to them. And those changes can be a variety of things from terms, you know, extra rights, you know, I talked about in convertible debt, you know, sometimes you get equity rights and debt rights and things like that.

Matthew Foreman [00:12:59]:
You know that that’s common. Ish. Most of them are pretty vanilla, but you do get some interesting flavors depending on what the parties agree to. But what is a safe right? I asked the question, don’t answer. And the answer is it’s really economic series of rights. The premise is you invest money in a business and if there is some liquidity event or some future investment, what happens is it converts into equity, into ownership in the company. It Is certainly not debt when you hold the equity, obviously that’s equity, but before it’s not debt because you don’t have any creditor rights. It says very explicitly in the safe that you’re not a creditor, you have no rights upon bankruptcy.

Matthew Foreman [00:13:38]:
You really can’t do a whole lot. This is where people modify it. You know, they really want to kind of get ahead of things and they want to have some rights or something like that. I’m not a huge fan of that. You know, if you want more, and I’ll get into this later, you know, use a convertible debt. If you want debt, have debt. If you want to safe, have safe. You want equity, have equity.

Matthew Foreman [00:13:55]:
You know, to choose what you’re doing. It’s probably not equity from a tax perspective. Generally speaking, there are some extremely specific situations where what I’m telling you is totally wrong. And it could be considered probably isn’t debt, but it could be considered equity. And I think that that’s really, really important. So, you know, people always ask me, well, what do I think it is? I don’t think it’s anything. If it has to be debt or equity, it’s probably some level of equity, but for the most part, they don’t have any meaningful or material economic rights. You know, you don’t get anything.

Matthew Foreman [00:14:29]:
You only get anything if it converts and conversion will happen in very specific situations. And what they generally are, I think of as three things. One, they sell the company. Two, they sell a significant portion of the assets. If you read the safe, it talks about it. I usually use the phrase substantially all, but it really can trigger if you don’t sell all, if you sell certain ones. You know, if a business kind of has two lines of businesses it’s focusing on, you know, if it splits the business apart, maybe it triggers things like that. So it’s important to read it, understand what the possibilities are, what you’re trying to do, and that’s really what happens.

Matthew Foreman [00:15:04]:
The third situation where it gets triggered is if there’s an investment. You know, I think that’s the most important one and probably the most common one is a lot of times what happens is safes are at the. What I call the friends, family and fools round. Not. Not my term, but that’s what I use. It’s when you go to people you know, and you say, hey, I got this idea, you know, let me do it, and like, I’ll give you 30 grand. But I, you know, I don’t really want to deal with a bankruptcy and I don’t really want this, but I don’t really want, you know, to deal with interest rates. And I don’t want to hurt you, but I want some.

Matthew Foreman [00:15:33]:
I want something in return. And what I’m going to get in return is X, Y or whatever it is. And that’s your safe, right? That’s the safe. And that’s the idea behind. It’s a very early investment strategy that tends not to happen once you have real rounds. And when I say real rounds, I mean, you know, when you think about the series A or things like that, it tends to be the, the first set of investments often is where safe sit. Once you hit the second series of investments, more, you know, larger ones. That’s when safes tends not tend not to happen.

Matthew Foreman [00:16:04]:
So that’s good. So upon, let’s say it converts, right? You know, well, let’s back up. Let’s say the safe never converts. The company just blows up. What happens? Probably long term capital loss. You take the loss, you lick your wounds, you’re going to move on. That’s it. I think it’s important, you know, to always recognize in any investment you could lose money.

Matthew Foreman [00:16:22]:
You know, I’m not saying you should invest in anything or shouldn’t invest in anything, but that’s the idea. Understand that there isn’t in fact material risk. I suspect I can probably give that as legal advice that investing in things is risky. You should consider not doing it right. That’s the idea. So basis, right? What is your basis? If the, if the safe converts right, then your basis is your call. However much you paid for the safe, that’s your basis in the stock. Pretty straightforward.

Matthew Foreman [00:16:48]:
You’re holding, period, right? You’re holding, period in the, in it is that this is where, you know, I’ve had a lot of conversation with it. I think you’re holding, period, chops itself in half and your holding period is upon conversion. Some people say, oh no, no, no. It’s, it’s when you invest in the safe, it’s like a convertible debt. I’m not totally sure on that. I understand why people say that. I think there’s an argument for it, but I’m not totally convinced that’s true. I, I’ve always think it is, but you know, that that’s where it is.

Matthew Foreman [00:17:17]:
I get a lot of questions, you know, what if I sell the safe? And I think this is really similar to, I talked about, you know, when you buy an option, non compensatory. I talked in a prior episode about those. But similar to selling the option Right. If you bought the option or you bought the safe, then it’s likely a capital asset. You have to look at what you do with them. If you’re the kind of person who buys safes or invests in safes and sells them, could be inventory, could be a trader, it might be ordinary income, but for most of us it’s probably capital gains. Obviously, holding period does, then it converts, right? And on that conversion you get a new holding period is a lot of how I view it. Again, we’re going to talk about qualified small business stock, right? Convertible debt and safes are very, very commonly used with things that are section 1202, qualified small business stock.

Matthew Foreman [00:18:02]:
The key of section 1202 is the issuance, the actual issuance of the stock. And I don’t think that it’s been issued upon the safe. I think it’s only issued, and I’m putting that in quotation marks of sorts when you convert, when it triggers the conversion from a safe to equity. Some people say that post money safes start with when the safe is purchased. I’m not convinced of that. There’s no authority for it. It’s not a position that I couldn’t, I would never take, but it’s definitely a position where I would be less likely to take it given just the complete lack of information. But it depends on the safe.

Matthew Foreman [00:18:41]:
Again, this is one situation where the sheer amount of just variety within safes and what they are, right. If you have a safe where you can vote, if you have a safe where you have some economic right, maybe, you know, I’m not saying the answer is no. It’s definitely not no. But it’s something to really think about and consider. And it’s one of the ones where I always say, you know, the devil’s in the details. I’m sure other people say that too. So I think that’s a really important question to have. So I think kind of the finalist question for me, right, Is why do people use safe, you know, why do people just not use convertible debt? There’s pretty form notes for convertible debt.

Matthew Foreman [00:19:18]:
If you’re doing a safe, most likely you have a lawyer, they can draw up the convertible debt. You know, I tell most of people, if they’re investors, you probably want convertible debt, especially if it’s on largely the same terms. You know, the reason people used to say, first off, they’re easier to document. There’s a form, it’s on the Internet. Everyone knows what it is. You know, Y combinator will say we’re, you know, we’re not representing anything, we’re not lawyers, et cetera, et cetera. But, like, everyone knows what it is. It’s been through a thousand, a million, whatever iterations.

Matthew Foreman [00:19:46]:
And I think there’s some real value there to the fact it’s been through them and everyone knows what it is. This isn’t like pulling an operating agreement off the Internet and you don’t know what it’s for. Why Combinator is known also in know this is really important if you’re investing in a company that’s at the point of a safe, okay. And it’s. The company ends up failing. Like, what are you going to get as a creditor? Do you really want, like, their laptops? Do you want, like, a desk? They bought, like, what are you, you know, So a lot of times what happens is there’s creditors ahead of you or there’s other things and the IP gets sold somewhere. So you may not really get anything anyway. So I’m not sure it helps.

Matthew Foreman [00:20:25]:
Plus, let’s be honest, if you’re going through this, you know, and actually goes through a bankruptcy, that’s very expensive, if it’s even bought out, or you just do certain things, there are other creditors likely ahead of you if you’re at this point. So I’m not really sure that the convertible debt gives you anything, but it depends. You know, you see people putting, you know, I’ve seen multimillion dollar safes over the years, and I’m just like, you know, maybe the convertible debt’s the way to go to have it a little more formalized and to think about it. And that may be for both the issuer, you know, the company and the person buying the convertible debt or the safe. Right. What do you actually want? What do you want to get out of it? There’s something, you know, especially early on, right. In 2013, and they reissued the new ones in 2018. But, you know, why Combinator? Why Combinator? You know, oh, I.

Matthew Foreman [00:21:10]:
I bought a safe, I bought a safe, and like, that’s, that’s fine, but sometimes just vanilla convertible debt is actually a better, easier instrument to use. You know, people always quibble with what is the valuation in safes and how do you run these numbers and what do you do? And convertible debt just says, okay, well, like, I get 400 shares of this stock or I get the value of this stock, you know, and that’s it. And safes are like, well, pre money and post money and whatever, you know, understanding where the triggers are. So there’s a simplicity in Both ways, right? You may say, well, we’re just going to use this document. Everyone agrees what it says. You know, it’s funny. Funny, the wrong word. But the document for the safe is shorter than the user guide.

Matthew Foreman [00:21:49]:
And I know people laugh, but you know, a lot of IRS forms are like that where they’ll have a two page form and 47 pages of instructions. And the truth is a lot of it is the fact that, you know, the way lawyers draft and I sure the Wide Combinator stuff was drafted by lawyers or at least heavily reviewed by lawyers, is we use terms that we all know what it means. And then if you actually want to define, you know, know, three words, right. The, whereas the recitals and things like that, it requires two paragraphs to explain a simple sentence because there’s just words behind words. And I think that’s one thing that people like is just the actual safe is very short, very brief. You sign it, you move on. You know, especially if you get a safe with very, very vanilla terms, you know, that are, that are very close to what was in the original safes. You don’t, you know, there really isn’t.

Matthew Foreman [00:22:37]:
You just say, this is, this is the deal, right? Them’s the breaks. So I think that’s something that really makes it a little easier. Whereas convertible debt is always kind of a start to negotiation, you know, of different points. And I think that that’s what really matters. So that’s the end of this episode. A little shorter of an episode, only one break. I know, I know you really want more of the music, but, you know, I hope this really helps a lot. And will you do it? I’ll be back in two weeks.

Matthew Foreman [00:23:00]:
I’m going to be discussing, as I said earlier, some comments that you. Local tax income, state and local income tax issues. I’ll get that eventually. And now for the best song of all time.