Convertible note

Until it converts, a convertible note is debt. The investor gets a promise of repayment, interest and the right to convert the balance into shares when a set event occurs. The note also has a maturity date, when the balance falls due if it has not converted. In a liquidation, debt is repaid before SAFEs and stock.

The tax code also treats an unconverted note as a debt instrument. Interest that builds up unpaid until maturity or conversion is original issue discount (OID). On a note longer than one year, the investor is taxed on OID as it accrues, even though no cash is paid. For example, a $100,000 two-year note at 6% simple interest, paid at maturity, carries $12,000 of OID. The investor reports $5,830 of it for the note’s first 12 months, at a constant yield of 5.83%. That is the yearly rate that compounds to $12,000 of interest over two years.

Two tax questions have no settled answer. The first is the company’s interest deduction, which it normally takes as the interest accrues. Section 163(l) denies that deduction on debt payable in the company’s own stock. No regulation says whether a note that converts automatically at the next round is covered. The second question is conversion. No Code section says outright that it is tax-free to the investor, and the answer can turn on the note’s terms.

For qualified small business stock (QSBS), the holding period starts when the note converts, so time spent holding the note adds nothing. The gross asset test also applies at conversion. For stock issued after July 4, 2025, the limit is $75 million, which may be adjusted for inflation after 2026.