Investing in convertible notes have becomes a popular note structuring transaction in 2023. As a result of the banking crisis and the reluctance of many banks to lend funds to small businesses, a growing number of small businesses and start-ups are looking to convertible notes as a way to finance their business or start-up.
This article will explore the use of convertible notes by Self-Directed IRA investors and some of the tax matters to consider when electing to use them with retirement funds.
- A convertible note allows a loan to be converted into equity instead of being paid back with interest
- A Self-Directed IRA can act as the lender to a business (the borrower)
- You must be aware of the tax implications of the equity, depending on the type of business entity involved
What is a Convertible Note?
A convertible note is a hybrid between a loan and equity investment where the loan can be converted into equity rather than being paid back solely in interest. Convertible notes are popular among start-up businesses that have trouble borrowing money from banks. At the same time, a convertible note or bond can also be used by mature businesses, such as publicly traded corporations. They are private instruments that can vary based on the terms agreed upon by the lender and borrower. However, it is common that when structuring a convertible note for a start-up, the note will convert based on a triggering event, which can be the startup’s next round of financing that exceeds an agreed-upon minimum threshold, a period of time, or on a specific business achievement.
In sum, a convertible note is originally structured as a debt investment but contains an option that allows the principle, plus accrued interest, to convert into an equity investment at a later date. This provides the lender with the potential economic upside of an equity investment, which is especially exciting for start-ups.
Below is a breakdown of the steps involved in making a convertible note investment:
Step 1: The convertible note holder (the Self-Directed IRA for our purposes) lends capital to a startup (the borrower). The terms of the convertible note is outlined in a convertible note agreement and promissory note.
Step 2: As part of the convertible note investment, the Self-Directed IRA lender earns interest while the loan is still outstanding, which is typically a short period (12-24 month is common). However, because the borrower is typically a start-up, the interest is usually paid in the form of an accrual; for example, the interest is added to the principle rather than paid in cash as interest.
Step 3: With a traditional loan, the borrower is contractually obligated to repay the principle on the maturity date. But in the case of a convertible note, the hybrid instrument will convert into equity, contingent on the terms of the note.
Equity vs. Debt vs. Convertible Notes
Below is a table that characterizes the differences between equity and debt, which is helpful in understanding the characteristics of being a lender versus an equity owner:
|Repayment of Investment||No guaranty of repayment until sale of company.||Repayment on fixed schedule.|
|Payment of Dividends or Interest||In the case of a corporation, dividends may be paid||No dividends. Interest paid on fixed schedule.|
|Payment on Sale of Company||Entitled to sale proceeds based on ownership percentage, subject to debt and other payments made first.||Paid prior to equity, and receives remaining capital plus any unpaid interest. Benefit limited to invested capital plus interest.|
How to Invest in a Convertible Note with a Self-Directed IRA
In order to invest in a convertible note in a private company using an IRA or rollover 401(k) plan, one will need to use a Self-Directed IRA, which is a plan that allows for alternative asset investments. Banks and traditional financial institutions do not generally offer alternative investments to their clients, which is why you need to self-direct your plan with a regulated trust company, such as IRA Financial.
The following are the steps required to use an IRA Financial SDIRA to invest in a convertible note investment:
- Setup an account at IRA Financial through our app
- Move funds from another retirement account to your new Self-Directed IRA tax free
- Provide IRA Financial with the convertible note documentation necessary to facilitate the note investment
- IRA Financial will send the money to borrower/corporation.
- The lender would be titled in the name of the IRA for the benefit of the IRA owner or in the name of an LLC, in the case of a Self-Directed IRA LLC. All interest would flow to the IRA tax-free, or in the case of a conversion, the equity would be titled in the name of the IRA.
Taxation of Self-Directed IRA Convertible Note Investments
Taxation of Debt
A convertible note starts out as a debt instrument. Therefore, from a taxation standpoint, a convertible note that is owned by a Self-Directed IRA is taxed as a loan. The interest and principle from a loan would return to the IRA without tax. Using an IRA to make a loan is very tax advantageous since interest on a loan is taxed as ordinary income – not capital gains – which could potentially save the IRA owner up to 37% in income tax.
Taxation of Equity Interests
Once the convertible note converts from debt to equity, the taxation of the equity interests is taxed based on the type of equity. In the case of a corporation, dividends would return to the IRA without tax. Whereas if the convertible note converted from debt to an equity interest in an LLC or other pass-through entity, profits allocated to the IRA over $1,000 could be subject to the UBTI tax. A pass-through business is a business, such as a store, that is operated via an LLC or other flow through entity. Whereas if a business is owned via a corporation, the UBTI tax would not apply since a C corporation is not a flow through entity as it has a corporate level tax.
In other words, the sale of the C corporation stock and all corporate dividends allocated to the IRA would not be subject to tax. The UBIT tax imposes a maximum 37% tax on pass-through income allocated to a IRA above $15,000 or so. However, the sale of the LLC interests would be tax-free and not subject UBTI, assuming the company did not have any outstanding leverage.
Hence, it is important to consider the tax implications if you are considering investing in a convertible note from a pass-through entity Note – a Self-Directed IRA may not invest in an S Corporation as an IRA is not an eligible S corporation shareholder based on the rules under the Internal Revenue Code.
Investing in convertible notes have become a popular way for investors to invest in start-ups and growth businesses. The hybrid nature of the convertible note gives the Self-Directed IRA the potential upside of an equity investor based on a contingent event. The tax advantages to lend money as well as own equity on a capital event makes the convertible note investment option very attractive for IRA investors.