Understanding Taxation and the Treatment of Interest on Convertible Notes

What Are Convertible Notes?

Fund managers can use a variety of methods to inject capital into companies. One popular instrument they use is convertible notes. Convertible notes blend the lower risk of investing through debt, offering the benefit of future equity. Many fund managers in the venture capital industry use convertible notes during the early rounds of funding when company valuations can be difficult to determine and when there is uncertainty around the future success of the company. Convertible notes usually have a stated interest rate and a maturity date. At the end of the term, the note may convert into equity, like preferred stock, based on the agreed terms instead of being repaid in cash.

Tax Implications of Convertible Notes

The hybrid nature of convertible notes presents unique tax consequences to companies that use this form of capitalization. While the expectation is for the note to convert into equity, any accrued interest on the note is generally taxed to the lender as interest income. Companies should be providing a Form 1099-INT that annually calculates the accrued interest income on the convertible note for the tax year. Further, fund managers must confirm with the company upon investment that they will be provided a Form 1099-INT during the period before the note is converted to equity. To avoid surprises, investors in funds using convertible notes should also be informed that they may receive taxable interest income reported on their Schedules K-1 even if no cash distributions are made. On a positive note, any accrued but unpaid interest is generally added to the tax basis of the shares at conversion of the instrument.

Qualified Small Business Stock and Convertible Notes

Fund managers seeking to obtain Qualified Small Business Stock (Section 1202, QSBS) treatment upon stock sale must wait for the convertible note to convert to equity before commencing the required five-year holding period. Fund managers who plan to take advantage of QSBS treatment in the venture capital market may seek to convert the note to equity as soon as possible to begin the clock on this holding period.

It is crucial for fund managers planning to use convertible notes to understand the tax implications on convertible note interest rates. Weaver’s tax professionals can help you navigate the key considerations to make informed decisions. Contact us today.

Authored by Conner Walker

©2025