Innovative Financial Structures and the IRS: What You Need to Know

Unexpected Tax Consequences Could Arise from Certain Early-Stage Investments

Increasingly, social impact entrepreneurs and investors are calling for investment structures that provide more liquidity, in contrast to traditional investment structures that look primarily to an IPO or major acquisition. Many investors deserve commendation for their creative efforts in modifying more traditional debt and equity instruments in order to preserve the unique goals of impact investing while incorporating this added liquidity. However, investors and entrepreneurs should also be aware of potentially adverse tax consequences that can result under these non-traditional investment structures.

Often, investors and entrepreneurs are surprised to discover that the US federal income tax treatment of their investments can differ substantially from their expectations, often as a result of one or both of the following tax regimes:

1. equity/debt recharacterization; and
2. the “original issue discount” (“OID”) rules.

Equity/Debt Recharacterization

US tax laws have developed their own framework for classifying investments as either equity or debt, rather than deferring to the form agreed upon by the parties to a transaction.  This means, for example, that even if an investor and company have signed documents for an equity deal and have treated it as an equity deal in their tax filings, the IRS could retroactively treat the transaction as a debt deal and charge interest income to the investor.  The IRS rules for characterization consider many factors. While too numerous to cover them all here, an important rule of thumb is that an equity deal with a redemption provision that can be triggered in less than 10 years should probably be reviewed by a knowledgeable tax advisor.

Original Issue Discount Rules

Separately, a set of provisions called the original issue discount (“OID”) rules can significantly alter the tax treatment of debt instruments.  Again, an investor and company can find that the IRS may impose additional income on an investment because the IRS views it as having different tax attributes than what the parties intended when they signed the deal documents.  With OID rules, there is a risk that the IRS could retroactively alter the tax treatment in the following ways:

• tax principal payments and/or repayment “premium” as interest;
•  attribute interest income to an investor even if interest is not required to be paid under the terms of the documents; and/or
• charge interest income at a higher rate than is required under the terms of the documents.

Generally speaking, the OID rules may apply in the following circumstances:

• if interest is not required to be paid in regular intervals and at least once in each calendar year during the term of the loan (e.g. the loan instrument contemplates an interest “holiday”);
• if interest can be added to principal in lieu of cash payment;
• if interest is charged at a “below market rate”;
• if the interest amount is variable or contingent (e.g. “stepped” or based on revenue or some other metric of company performance) rather than fixed;
• if the principal value of the loan is discounted; and
• if a loan agreement is paired with a related agreement (e.g. a revenue share agreement or warrant).

The last point is of particular importance, as the parties may not realize that the IRS has the ability to combine separate but related agreements for the purpose of assessing the tax treatment of the entire transaction.  Some common areas of concern with respect to related agreements triggering or contributing to unexpected tax results are as follows:

• a revenue share agreement that provides for variable payments based on company performance; and
• a debt instrument paired with a warrant agreement in which the exercise price of the warrant is less than the fair market value of the company’s stock on the date of issue.

Section 305 Rules

Equity instruments are not subject to the OID rules, but may be subject to an analogous set of deemed dividend rules unless characterized as either common stock or “participating preferred” stock for US federal income tax purposes.  Under these analogous rules, for example, accrued dividends may be subject to income tax even if not paid and certain payments could be taxed as ordinary income even if capital gains treatment was expected.

Very generally speaking, preferred stock should be treated as “participating preferred” and not subject to these rules if upon a liquidation event the investor is paid the greater of either (i) the investor’s liquidation preference or (ii) the amount that would be paid to the investor if the preferred stock converted immediately prior to the liquidation event. “Participating preferred” status may also be lost if the stock is mandatorily redeemable or subject to a redemption option.  In US venture capital deals, the “greater of” provision is standard and there is rarely a built-in option to redeem.  At a minimum, investors and companies will want to confirm that the same or similar language is included in their documents, even if the equity is issued outside of the US.

Here are two examples of how the re-characterization, OID, and Section 305 rules could be triggered:

Example #1 – Recharacterization and OID Accruals

A corporation issues convertible preferred stock that entitles the holders to a liquidation preference equal to the greater of a 14% return or the amount that would be received if converted. The holders also have the right to require that the corporation redeem the preferred stock for 3 times the issue price at any time after 5 years (provided there is sufficient profit).

For US federal income tax purposes, the instrument could be characterized as debt, largely due to the investor redemption option after only 5 years. As debt, the OID rules could: (a) characterize as interest the expected payments from the liquidation preference and/or the redemption premium, and (b) include such deemed interest in the investors’ taxable income. However, even if the instrument were to retain equity characterization for tax purposes, the parties should consider whether the liquidation preference could create taxable deemed dividend payments under the Section 305 rules.

Example #2 – OID Accruals Only

A corporation issues 10-year notes with a fixed rate of interest and principal due at maturity. The notes contain an interest-payment “holiday” for the first 2 years. In addition, lenders are granted a “revenue share” right to distributions of 2% of net revenue for as long as the notes are outstanding.

In most cases, the “revenue share” right would be characterized as a payment on the debt instrument itself. The OID rules would likely be triggered by the variable nature of the “revenue share” right and the payment “holiday,” requiring investors to report and pay tax on deemed payments of interest over the life of the note (likely commencing before actual payments).

Consequences of Non-Compliance

The tax rules affecting debt/equity characterization and OID are extremely complicated and can impact different instruments and parties in significantly different ways, making it impossible to accurately estimate the cost of non-compliance without thorough analysis of the instrument at issue.

For example, the situation described in Example #1 could trigger taxable deemed interest payments, subject to the higher ordinary-income tax rates and occurring in pre-payment tax years. Investors not reporting these payments could be subject to interest and penalties. By contrast, certain tax-exempt investors such as charities and retirement plans may be relatively unaffected by these tax rules.

Investors and entrepreneurs are encouraged to seek guidance on the effect of these recharacterization and OID rules, particularly with respect to transactions containing terms similar to those discussed here.

Brian Mikulencak provided most of the content for this blog.  Brian regularly collaborates with our firm on tax-related matters.   He specializes on the tax treatment of business transactions, including with respect to choice-of-entity analysis, structuring investments, and non-profit formation and operations.

This content is provided solely for general informational purposes.  It does not constitute legal advice regarding any specific facts and circumstances, and its dissemination does not create an attorney-client relationship.   If you are interested in learning more or want to discuss a particular situation, you should contact one of us or another attorney or tax adviser.