Convertible Note Tax Treatment: Interest, Conversion, and OID

The tax treatment of a convertible note follows a simple arc with sharp edges: while you hold it, it’s taxed as debt and throws off interest income (often before any cash arrives); when it converts into stock, the exchange is generally tax-free except for the piece attributable to accrued interest; and if the company fails or you sell early, the loss or gain is usually capital in character. The traps sit in the details. Interest can accrue as phantom income under the original issue discount rules, the IRS can recharacterize the whole instrument as equity if it doesn’t look enough like a real loan, and the shares you receive in exchange for unpaid interest at conversion are ordinary income even when the rest of the conversion is not.

How the Note Is Taxed While You Hold It

Assuming the note is respected as debt, two mechanisms can produce taxable interest income each year: stated interest actually paid, and original issue discount that accrues whether or not cash changes hands.

Stated Interest

Cash interest is ordinary income to the investor under Section 61, which sweeps interest from all sources into gross income.¹ The issuing company deducts the same payments under Section 163.² Nothing exotic there. The complications start when the note carries little or no cash-pay interest, which describes most startup convertible notes.

Original Issue Discount and Phantom Income

OID arises when a note is issued for less than the amount payable at maturity. A $100,000 note sold for $95,000 has $5,000 of built-in OID that compensates the lender for the discount. Zero-coupon notes and low-coupon convertible notes routinely generate OID.

Section 1272 makes the investor include OID in income annually using a constant-yield method, whether or not any cash has been received. Each accrual period’s OID equals the note’s adjusted issue price at the start of the period multiplied by the yield to maturity, less any stated interest payable in that period.³ That’s the phantom income problem: you owe tax on interest you haven’t actually collected. The issuer takes a matching deduction as the OID accrues, so the two sides mirror.

OID that hasn’t yet been included in income also affects how you’re taxed if the note is later retired or sold. Section 1271 can convert what would otherwise be capital gain into ordinary income to the extent of unaccrued OID.⁴

Below-Market Rates and the AFR

If your note’s stated interest is below the applicable federal rate the IRS publishes each month, the shortfall can be treated as additional OID. This matters for startup notes, which often carry token interest rates or none at all. The rate in effect at issuance is the one that governs, and the AFR has short-term, mid-term, and long-term tiers.⁵ Investors holding zero-interest convertible notes should plan on annual imputed OID even without cash coupons.

Contingent Payment Features

Some notes tie payments to the issuer’s performance: interest keyed to revenue, or conversion prices that float on future valuations. Those can push the note into the contingent payment debt instrument rules, which force accrual using a “noncontingent bond method” based on a comparable yield the issuer would pay on a similar fixed-rate note. The result is often more phantom income than the note’s face terms suggest. Remote contingencies (roughly a 5% or less probability), insignificant amounts, and standard floating-rate features like SOFR don’t trigger CPDI treatment. Interest linked to stock price, revenue, or profits does.

When the IRS Treats the Note as Equity Instead

All of the above assumes the note is respected as debt. Section 385 gives Treasury authority to write regulations distinguishing debt from equity, and federal courts have long applied a multi-factor test to the same question.⁶ Factors that push toward equity treatment include deep subordination, an interest obligation payable only out of profits, a thin debt-to-equity ratio, and noteholders who are also the stockholders in roughly matching proportions. A note with a firm maturity date, a reasonable interest rate, and a genuine expectation of repayment independent of the company’s success generally survives as debt.

The issuer’s characterization at issuance binds the issuer and every holder, but not the IRS.⁶ Calling something a note doesn’t make it one.

Reclassification is expensive. The “interest” payments become dividends, which the issuer cannot deduct. For the investor, the same payments become dividend income rather than interest income; whether they qualify for the lower qualified-dividend rate depends on the company’s status and the investor’s holding period. The permanent loss of the interest deduction is usually the bigger hit.

What Happens at Conversion

Converting the note into the issuer’s stock is generally not a taxable event. The conversion is treated as a recapitalization under Section 368(a)(1)(E),⁷ and Section 354 provides nonrecognition when securities in a corporation are exchanged solely for stock or securities in the same corporation as part of the reorganization plan.⁸

Basis and Holding Period Carry Over

Your basis in the note becomes your basis in the stock. Paid $100,000 for the note and reported $3,000 of OID as income along the way? Your basis in the note is $103,000, and the shares you receive inherit that same $103,000 basis. Any embedded gain, including the discount to the current share price that made the conversion attractive, is deferred until you sell the stock.

The holding period carries over too. Under Section 1223, when new property takes the same basis as the property surrendered, the holding period of the original property tacks onto the new.⁹ Hold the note fourteen months before converting, and the resulting stock is already past the one-year threshold for long-term capital gains treatment on a later sale.

The Accrued Interest Trap

Section 354 pointedly carves accrued interest out of nonrecognition. To the extent shares you receive at conversion are attributable to interest that accrued during your holding period and hasn’t already been included in income, that portion is taxable as ordinary income in the year of conversion.⁸

This is where investors get surprised. Most startup notes accrue interest but never pay it in cash; at conversion, the accrued interest rolls into additional shares alongside the principal. Those additional shares are not tax-free. You pick up their fair market value as ordinary income even though nothing about the transaction produced cash. Investors who don’t plan for it can face a real tax bill with nothing liquid to cover it.

Cash for Fractional Shares

If you receive anything other than stock in the exchange, such as cash in lieu of fractional shares, nonrecognition breaks to that extent. You recognize gain (not loss) equal to the lesser of the cash received or the total gain built into the exchange. In practice, fractional-share cash-outs are small capital gains.

If You Sell, Get Repaid, or Renegotiate the Note

Conversion isn’t the only exit.

Repayment at Maturity

Compare the repayment amount to your adjusted basis, which is your original purchase price plus any OID already included in income. Repayment above basis is capital gain; below basis is capital loss. Because your basis has been climbing with each OID accrual, the gain at maturity is typically smaller than the raw numbers suggest.

Sale to a Third Party

Selling the note produces capital gain or loss equal to the difference between sale proceeds and adjusted basis. Held for more than one year, the gain is long-term. Report the sale on Form 8949 and carry the results to Schedule D.¹⁰

Modifying the Terms

Renegotiating a convertible note can accidentally trigger a taxable event. Under Treasury Regulation 1.1001-3, a “significant modification” of a debt instrument is treated as if the old note were exchanged for a new one. That deemed exchange can produce gain or loss and restart the holding period.¹¹ Changing the conversion price, materially extending maturity, or altering the interest rate can all cross that line. Run the analysis before signing an amendment, not after.

If the Note Becomes Worthless

Startups fail. The deduction you can claim depends on whether the note qualifies as a “security” and whether you’re in the business of lending money.

A note issued in registered form by a corporation, or with interest coupons, is a “security” for these purposes. If it becomes wholly worthless, it’s treated as sold for zero on the last day of the tax year, producing a capital loss.¹² Long-term if held more than a year, short-term otherwise. Capital losses offset capital gains dollar-for-dollar and up to $3,000 of ordinary income per year, with the rest carried forward.

Many startup convertible notes are simple promissory notes that don’t meet the security definition. When those go bad, Section 166 governs. For an investor who isn’t in the lending business, a worthless nonbusiness note is treated as a short-term capital loss regardless of how long it was held.¹³ The debt must be wholly worthless; partial worthlessness deductions are available only for business debts.

One boundary worth naming: Section 1244, which converts losses on qualifying small-business stock into ordinary losses, does not apply to a convertible note. It’s not stock. If the company fails before conversion, you can’t claim a 1244 ordinary loss on the note itself.

Tax Consequences for the Issuing Company

The issuer’s picture largely mirrors the investor’s, with a few additions.

Interest Deductions Are Capped

The issuer deducts stated interest and accruing OID as they accrue,² but Section 163(j) caps total business interest deductions at 30% of adjusted taxable income (plus business interest income and floor plan financing interest), with any excess carried forward.¹⁴ Early-stage companies with little taxable income can end up deferring the benefit indefinitely.

Conversion Is a Non-Event

Issuing new equity in exchange for outstanding debt produces no gain or loss for the corporation. The balance sheet moves the item from liabilities to equity; the tax return stays quiet.

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 61.¹ Section 108 provides relief when it’s most likely to be needed. If the company is insolvent at the time of discharge (liabilities exceeding the fair market value of assets), the COD income is excluded up to the amount of insolvency. In a bankruptcy case, the entire amount is excluded.¹⁵ The trade-off is a required reduction of tax attributes (net operating losses, credit carryovers, asset basis) in a statutory order, so the exclusion protects cash today at the cost of losses that might otherwise have sheltered future income.

1
Office of the Law Revision Counsel. 26 US Code 61 – Gross Income Defined
2
Office of the Law Revision Counsel. 26 US Code 163 – Interest
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Office of the Law Revision Counsel. 26 USC 1272 – Current Inclusion in Income of Original Issue Discount
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Office of the Law Revision Counsel. 26 US Code 1271 – Treatment of Amounts Received on Retirement or Sale or Exchange of Debt Instruments
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Internal Revenue Service. Revenue Ruling 2026-6 – Federal Income Tax Rates for March 2026
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Office of the Law Revision Counsel. 26 US Code 385 – Treatment of Certain Interests in Corporations as Stock or Indebtedness
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Office of the Law Revision Counsel. 26 US Code 368 – Definitions Relating to Corporate Reorganizations
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Office of the Law Revision Counsel. 26 US Code 354 – Exchanges of Stock and Securities in Certain Reorganizations
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Office of the Law Revision Counsel. 26 US Code 1223 – Holding Period of Property
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Internal Revenue Service. About Form 8949
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eCFR. 26 CFR 1.1001-3 – Modifications of Debt Instruments
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eCFR. 26 CFR 1.165-5 – Worthless Securities
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Office of the Law Revision Counsel. 26 US Code 166 – Bad Debts
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Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense
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Office of the Law Revision Counsel. 26 USC 108 – Income From Discharge of Indebtedness