Convertible Note Tax Treatment: Debt, OID, and Conversion

The tax treatment of a convertible note follows a two-stage pattern: while you hold it, it is taxed as debt, with interest (and often original issue discount) reported as ordinary income each year; when it converts into the issuer’s stock, the exchange is generally tax-free, except for the portion of stock attributable to accrued but unpaid interest. Between those two points sit several traps that catch investors and issuers alike, including phantom income on notes that pay no cash interest, reclassification of the whole instrument as equity, and unexpected income on the interest slice at conversion.

Is It Really Debt? Classification Comes First

Every other tax question depends on whether the IRS accepts the note as debt. Section 385 of the Internal Revenue Code authorizes Treasury to write regulations for this determination and lists factors the regulations may weigh, including whether there is a written unconditional promise to pay a fixed sum on a specific date at a fixed rate, whether the note is subordinated to other creditors, the company’s debt-to-equity ratio, the presence of a conversion feature, and whether the noteholders and stockholders are the same people in roughly the same proportions.¹ These are evaluated together, not scored on a checklist.

The issuer’s own characterization of the instrument at issuance is binding on the issuer and all holders, but not on the IRS.¹ Calling something a note doesn’t make it one. A note with a firm maturity date, a reasonable interest rate, and a genuine expectation of repayment tends to survive. A deeply subordinated note that pays interest only out of profits and is held pro rata by the existing stockholders is exposed.

If the IRS reclassifies the note as equity from the start, “interest” becomes a dividend. The issuer loses the deduction permanently, which is usually the larger financial hit, and the investor picks up dividend income instead of interest income, with qualification for the lower dividend rate depending on the company’s status and the investor’s holding period.

Interest and Original Issue Discount While You Hold the Note

Assuming the note holds as debt, two mechanisms generate taxable interest income during the holding period: stated interest actually paid, and original issue discount that accrues whether or not any cash changes hands.

Stated Interest

Cash interest is ordinary income to the investor under Section 61² and deductible by the issuer under Section 163.³ Nothing exotic there. The complication starts when the note pays little or no cash.

OID and Phantom Income

Original issue discount arises when a note is issued for less than its face value at maturity. A $100,000 note sold for $95,000 carries $5,000 of built-in interest as OID. Zero-coupon notes and low-interest convertibles routinely generate it.

Section 1272 requires the investor to include OID in gross income each year on a constant-yield basis, even without any cash payment. Each accrual period’s OID equals the note’s adjusted issue price at the start of the period multiplied by its yield to maturity, less any stated interest payable during that period.⁴ That produces phantom income: tax owed on interest not yet received. The issuer deducts the same accrued amount, so the two sides mirror. When the note is later retired or sold, Section 1271 governs the treatment, and any gain traceable to OID not already included in income can be recharacterized as ordinary rather than capital.⁵

Below-Market Interest and the AFR

Many startup convertible notes carry little or no stated interest. The applicable federal rate operates as a minimum benchmark, and any shortfall below the AFR may be treated as additional OID, generating more phantom income for the investor and a matching deduction for the issuer. The IRS publishes AFRs monthly. For March 2026, the rates are 3.59% short-term (up to three years), 3.93% mid-term (over three to nine years), and 4.72% long-term (over nine years).⁶ Most convertible notes mature within one to three years, so the short-term or mid-term rate usually applies. The AFR in effect at issuance is the one that matters for a particular note.

What Happens When the Note Converts to Stock

Conversion into the issuer’s stock is generally non-taxable. The exchange is treated as a recapitalization, and Section 354 provides that no gain or loss is recognized when securities in a corporation are exchanged solely for stock or securities in the same corporation as part of the reorganization plan.⁷

Basis and Holding Period Carry Over

Your basis in the note becomes your basis in the stock. If you paid $100,000 for the note and reported $3,000 of OID income along the way, your basis is $103,000, and the new shares inherit that same figure. The gain built into any conversion discount is deferred until you sell the shares.

Holding period also tacks. Under Section 1223, when the new property takes the same basis as the property surrendered, the time you held the note counts toward the holding period of the stock.⁸ Fourteen months in the note means the stock is already past the one-year long-term threshold on day one.

The Accrued Interest Carve-Out

This is where investors get caught. Section 354 explicitly carves accrued interest out of non-recognition. To the extent shares received in the conversion are attributable to interest that accrued during your holding period and hasn’t already been picked up in income, that portion is ordinary income in the year of conversion.⁷

Most startup notes accrue interest but never pay it in cash. That accrued interest converts into extra shares alongside the principal, and the shares tied to the interest are taxable. Report their fair market value as ordinary income; the principal portion stays non-taxable. Investors who don’t plan for this receive a tax bill at conversion with no cash to pay it.

Cash for Fractional Shares

Anything received in the conversion besides stock breaks non-recognition to that extent. Cash in lieu of fractional shares triggers gain (not loss) up to the amount of cash received, and small fractional-share payments are reported as capital gains.

Repayment, Sale, or Renegotiation Before Conversion

Not every note converts. Three other paths carry their own tax consequences.

Repayment at Maturity

Compare the repayment amount to your adjusted basis, which is your purchase price plus any OID already included in income. Repayment above basis is capital gain; below basis is capital loss. Because OID accruals raise basis over time, the gain at maturity is usually smaller than it looks on the surface.

Sale to a Third Party

A sale before maturity or conversion produces capital gain or loss for the difference between proceeds and adjusted basis. More than a year of holding brings long-term rates, which in 2026 are 0%, 15%, or 20% depending on taxable income. The transaction is reported on Form 8949 and carried to Schedule D.⁹

Amending the Note

Renegotiating a convertible note can quietly trigger a taxable event. Under Treasury Regulation 1.1001-3, a “significant modification” of a debt instrument is treated as an exchange of the old note for a new one, potentially producing gain or loss and restarting the holding period.¹⁰ The rule applies whether the change comes through a formal amendment, a side letter, or an indirect transaction. Changing the conversion price, extending maturity substantially, or altering the interest rate can all cross the threshold. Run the analysis before signing.

If the Company Fails

When a startup collapses, the loss deduction depends on whether the note qualifies as a “security” for tax purposes and whether the investor is in the business of lending.

A note issued in registered form by a corporation, or one with interest coupons, is a “security.” Complete worthlessness produces a capital loss, treated as if the security were sold for zero on the last day of the tax year.¹¹ The loss is long-term if the holding period exceeds one year. Capital losses offset capital gains dollar-for-dollar, then up to $3,000 of ordinary income per year, with the balance carried forward.

Many startup convertible notes are simple promissory notes and don’t meet the security definition. Those fall under Section 166’s bad-debt rules. For an investor not in the lending business, a worthless note is a nonbusiness bad debt and is treated as a short-term capital loss regardless of how long it was held.¹² The debt must be entirely worthless; partial-worthlessness deductions are available only for business debts.

One boundary worth stating plainly: Section 1244 ordinary-loss treatment for small-business stock is not available for a convertible note. A note is not stock. If the company fails before conversion, the investor cannot claim a 1244 ordinary loss; that benefit exists only after the note has converted into qualifying stock.

Notes With Contingent Payments

Some convertible notes tie payments to the issuer’s performance, such as interest keyed to revenue targets or conversion prices that float on future valuations. When payments depend on uncertain future events, the note may fall under the contingent payment debt instrument rules.

Under the CPDI regime, the investor accrues income by the noncontingent bond method, using a comparable yield: the rate the issuer would pay on a similar fixed-rate instrument. That can generate higher phantom income than the note’s stated terms, because the comparable yield reflects the full economic return the market would demand, including the value of the conversion option.

Not every uncertainty triggers CPDI treatment. Default risk doesn’t count. Remote contingencies (roughly 5% probability or less) and contingencies affecting only insignificant amounts are excluded. Interest tied to a standard floating rate like SOFR is handled under the variable-rate debt instrument rules instead. But interest linked to the company’s stock price, revenue, or profits is not a qualified floating rate and pushes the note into CPDI territory.

The Issuer’s Side of the Ledger

For the issuing company, most of the picture mirrors the investor’s, with a few additions.

Interest Deductions and the 163(j) Cap

If the note is respected as debt, the issuer deducts stated interest and accrued OID as they accrue.³ Section 163(j) then caps the total business interest deduction at 30% of adjusted taxable income, plus business interest income and floor plan financing interest, with any excess carried forward.¹³ For early-stage companies with little or no taxable income, the cap can defer the benefit indefinitely. The limitation runs at the entity level and applies even if the only debt on the books is convertible notes.

No Gain on Conversion

The issuer recognizes no gain or loss when the note converts. A corporation doesn’t realize income by issuing its own equity, so trading debt for newly issued shares is a balance-sheet move, not a tax event.

Cancellation of Debt Income

If the issuer buys back or retires the note for less than its adjusted issue price, the difference is cancellation-of-debt income, taxable as ordinary income under Section 61.² For a struggling company, that’s a tax bill at the worst moment.

Section 108 provides relief. If the company is insolvent when the debt is discharged (liabilities exceed the fair market value of assets), COD income is excluded up to the amount of insolvency. In a bankruptcy case, the full amount is excluded.¹⁴ The trade-off: excluded amounts reduce tax attributes such as net operating losses, credit carryovers, and asset basis, in a set statutory order. For a company already insolvent when it settles, the exclusion prevents a tax liability it couldn’t pay, at the cost of losses it might otherwise have used later.

1
Office of the Law Revision Counsel. 26 US Code 385 – Treatment of Certain Interests in Corporations as Stock or Indebtedness
2
Office of the Law Revision Counsel. 26 US Code 61 – Gross Income Defined
3
Office of the Law Revision Counsel. 26 US Code 163 – Interest
4
Office of the Law Revision Counsel. 26 USC 1272 – Current Inclusion in Income of Original Issue Discount
5
Office of the Law Revision Counsel. 26 US Code 1271 – Treatment of Amounts Received on Retirement or Sale or Exchange of Debt Instruments
6
Internal Revenue Service. Revenue Ruling 2026-6 – Federal Income Tax Rates for March 2026
7
Office of the Law Revision Counsel. 26 US Code 354 – Exchanges of Stock and Securities in Certain Reorganizations
8
Office of the Law Revision Counsel. 26 US Code 1223 – Holding Period of Property
9
Internal Revenue Service. About Form 8949
10
eCFR. 26 CFR 1.1001-3 – Modifications of Debt Instruments
11
eCFR. 26 CFR 1.165-5 – Worthless Securities
12
Office of the Law Revision Counsel. 26 US Code 166 – Bad Debts
13
Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense
14
Office of the Law Revision Counsel. 26 USC 108 – Income From Discharge of Indebtedness