Converting debt to equity means a company issues shares to a creditor in exchange for wiping out what it owes. The creditor gives up a fixed repayment right and takes an ownership stake instead. That single swap sets off a cascade: the company may owe tax on cancellation-of-debt income, the creditor generally recognizes gain or loss on a taxable exchange, the new shares are restricted securities under federal law, the company’s net operating losses can be capped going forward, and if the company is insolvent at the time, the deal itself can be unwound as a fraudulent transfer. Getting the structure, valuation, and paperwork right is what separates a clean recapitalization from a lawsuit two years later.
Why the Swap Happens
Three situations drive most conversions. The first is financial distress: a company that cannot service its debt offers equity in exchange for forgiveness, and the creditor accepts to avoid a total wipeout in bankruptcy. The second is startup financing through convertible notes, short-term debt designed from day one to convert into equity at the next funding round, typically with a 15% to 25% discount on the new investors’ price and a valuation cap. The third is strategic recapitalization, where a solvent but overleveraged company cleans up its balance sheet before raising capital, pursuing an acquisition, or going public.
Which of the three you’re doing matters, because the tax and securities analysis shifts with the facts. A distressed conversion probably produces cancellation-of-debt income; a note conversion under original terms usually does not create a gain or loss for the company at all. A bankruptcy conversion opens exclusions unavailable outside Title 11.
How Many Shares the Creditor Gets
Valuation drives the share count, and the share count drives everything else. In a distressed deal, the company’s equity is often worth less than the face value of the debt, so the parties rely on a discounted cash flow model or a liquidation analysis. Those two approaches routinely produce very different numbers, and the choice can swing the creditor’s ownership by double-digit percentages.
For a convertible note, the math is written in advance. The conversion price is the lower of the valuation cap divided by the company’s fully diluted shares, or the new investors’ per-share price minus the negotiated discount. The note holder gets whichever calculation produces more shares.
Common Stock, Preferred Stock, or Both
Common stock is the simplest outcome: a basic ownership interest with voting rights, on equal footing with existing common shareholders.1Legal Information Institute. Common Stock In a negotiated distressed deal, common alone rarely gives the creditor enough protection to justify giving up a senior claim.
Preferred stock does. Its central feature is a liquidation preference: if the company is later sold or dissolved, preferred holders get paid before common holders. Non-participating preferred lets the holder choose between taking their preference or converting to common and sharing pro rata, whichever pays more. Participating preferred lets the holder collect the preference and then share in what’s left, which effectively pays them twice from the same pool. Anti-dilution provisions, usually on a weighted-average basis, protect the preferred holder if the company later raises money at a lower valuation.
If the conversion requires more shares than the charter authorizes, or introduces a new class of stock, the articles of incorporation have to be amended first. That takes a board resolution and, once any shares are outstanding, shareholder approval.
Securities Law: Registration or Exemption
Issuing stock for debt is a securities transaction. The company must either register the offering or fit an exemption. Three exemptions cover most conversions.
Section 3(a)(9) of the Securities Act exempts any security exchanged by an issuer with its existing security holders, provided no commission is paid for soliciting the exchange.2eCFR. 17 CFR 230.149 – Definition of Exchanged in Section 3(a)(9) Because the creditor already holds a security of the issuer (the debt), this is often the cleanest path for a bilateral swap.
When 3(a)(9) doesn’t fit, Regulation D usually does. Rule 506(b) allows an unlimited raise from an unlimited number of accredited investors plus up to 35 sophisticated non-accredited investors, but prohibits general solicitation.3U.S. Securities and Exchange Commission. Private Placements – Rule 506(b) Rule 506(c) permits general solicitation but requires every purchaser to be a verified accredited investor.4U.S. Securities and Exchange Commission. General Solicitation – Rule 506(c) Both require a Form D filing within 15 days of the first sale.
When the New Shares Can Be Resold
Shares issued in an unregistered offering are restricted securities and cannot be freely resold until Rule 144’s conditions are met. The holding period is six months for SEC-reporting companies and one year for non-reporting companies. A creditor gets a helpful timing rule: the holding period for the new shares tacks back to the date the creditor originally acquired the debt, even if the original debt wasn’t convertible by its terms.5eCFR. 17 CFR 230.144 – Persons Deemed Not to Be Engaged in a Distribution A creditor who held the loan for two years before conversion can often resell immediately.
What the Company Owes in Tax
The central tax question for the company is cancellation-of-debt (COD) income. When a corporation transfers its own stock to satisfy a debt, the Internal Revenue Code treats the company as having paid an amount equal to the fair market value of that stock.6Office of the Law Revision Counsel. 26 U.S. Code 108 – Income From Discharge of Indebtedness If the stock’s fair value is less than the face amount of the debt, the difference is COD income.
Extinguish $1,000,000 of debt with stock worth $800,000, and the company has $200,000 of COD income. That income is taxable unless a statutory exclusion applies.
Bankruptcy and Insolvency Exclusions
Two exclusions cover most real conversions. COD income is excluded when the discharge occurs in a Title 11 bankruptcy case. It’s also excluded to the extent the company is insolvent at the time of the discharge, meaning its liabilities exceed the fair market value of its assets.7Office of the Law Revision Counsel. 26 USC 108 – Income From Discharge of Indebtedness
The exclusion is not free. In exchange for keeping COD income out of taxable income, the company reduces its tax attributes in a prescribed order: net operating losses first, then general business credit carryovers, minimum tax credits, capital loss carryovers, property basis, passive activity loss carryovers, and finally foreign tax credit carryovers. NOLs and capital losses drop dollar-for-dollar; credit carryovers drop by 33⅓ cents per dollar of excluded COD income.6Office of the Law Revision Counsel. 26 U.S. Code 108 – Income From Discharge of Indebtedness The reductions happen after computing tax for the discharge year, and the company reports them on Form 982.8Internal Revenue Service. About Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness
What the Creditor Owes in Tax
For the creditor, converting debt to stock is generally a taxable exchange. The creditor recognizes gain or loss equal to the difference between the fair market value of the stock received and the creditor’s adjusted basis in the debt.9Office of the Law Revision Counsel. 26 U.S. Code 1001 – Determination of Amount of and Recognition of Gain or Loss The basis in the new stock equals its fair market value on the exchange date.
A creditor who previously wrote the debt down, or who bought it at a discount on the secondary market, has a low basis. That low basis makes gain more likely even when the stock received is not particularly valuable.
The character of a loss depends on whether the debt was a business or non-business debt. A business debt loss is ordinary, fully deductible against other income. A non-business debt loss is a short-term capital loss regardless of holding period, subject to the $3,000 annual limit against ordinary income ($1,500 for married filing separately), with unused amounts carried forward.10Internal Revenue Service. Topic No. 453, Bad Debt Deduction
The Narrow Section 351 Path
One route avoids gain or loss recognition. Under Section 351, no gain or loss is recognized when property is transferred to a corporation solely in exchange for stock, provided the transferor (or transferors acting together in the same transaction) owns at least 80% of the corporation’s voting power and 80% of all other classes of stock immediately after the exchange.11Office of the Law Revision Counsel. 26 U.S. Code 351 – Transfer to Corporation Controlled by Transferor Debt counts as “property” for this purpose. If Section 351 applies, the creditor takes a carryover basis from the old debt into the new stock instead of a fair market value basis.
Most conversions don’t hit the 80% control threshold. A creditor who ends up with a minority stake will recognize gain or loss under the general rules.
Section 382 and the Company’s NOLs
A large conversion can trigger the ownership-change rules that cap how much of the company’s pre-existing net operating losses it can use going forward. Section 382 applies when one or more 5% shareholders increase their combined ownership by more than 50 percentage points during a rolling testing period.12eCFR. 26 CFR 1.382-2T – Definition of Ownership Change Under Section 382 Handing a creditor a significant stake can trip that threshold easily.
Once triggered, annual use of pre-change NOLs is capped at the fair market value of the company’s stock immediately before the ownership change, multiplied by the federal long-term tax-exempt interest rate. For a distressed company whose stock is worth very little, the annual cap can be small enough to make the NOLs nearly worthless.
The Bankruptcy Carve-Out
Section 382 has a special rule for bankruptcy. If the old shareholders and qualifying creditors together own at least 50% of the reorganized company’s stock after the change, the annual cap does not apply. The price is that the company reduces its pre-change NOLs by interest deductions claimed on the converted debt during the three tax years before the change and the portion of the change year before conversion.13Office of the Law Revision Counsel. 26 U.S. Code 382 – Limitation on Net Operating Loss Carryforwards and Certain Built-In Losses Following Ownership Change Companies that can’t meet the 50% test, or find the NOL clawback too steep, can elect the regular Section 382 limitation instead.
Accounting Treatment
Whether the company reports a gain or loss on its income statement depends on whether the conversion follows the original terms of a convertible instrument or is negotiated outside them.
When a convertible note or bond converts exactly as designed, U.S. GAAP generally requires no gain or loss. The carrying amount of the debt, including any unamortized discount, is reclassified from liabilities to equity, with par value credited to the stock account and any excess to additional paid-in capital.
When the conversion is negotiated outside the original terms, or the instrument had no conversion feature to begin with, the transaction is an extinguishment of debt. The company removes the full carrying amount of the liability and records the fair value of the equity issued in its place, with the difference recognized as a gain or loss in the current period on a separate line item. A gain arises when the fair value of the shares issued is less than the debt carrying amount, which is common in distressed conversions. Auditors scrutinize the valuation supporting the fair value calculation closely, because it directly determines the reported gain or loss.
Fraudulent Transfer Risk
A conversion done while a company is insolvent, or one that pushes it into insolvency, can be attacked as a fraudulent transfer. Under the Bankruptcy Code, a trustee can avoid any transfer made within two years before a bankruptcy filing if the debtor received less than reasonably equivalent value and was insolvent at the time, or became insolvent as a result.14Office of the Law Revision Counsel. 11 U.S. Code 548 – Fraudulent Transfers and Obligations Transfers made with actual intent to defraud other creditors can be avoided regardless of value received.
The classic fact pattern is a related-party creditor receiving equity worth significantly more than the debt forgiven. If the company later files for bankruptcy and the equity is found to have been overvalued, the transaction can be unwound: the creditor loses the stock, the debt may be reinstated, and the creditor is back where they started, only now inside a bankruptcy case. The strongest protection is an independent third-party valuation done at the time of the transaction, documented contemporaneously and supported by market data or a recognized methodology. For any conversion where solvency is in question, that valuation is not optional.