LLCs and Convertible Debt – Too Good to be True?

By Scott Pinarchick and Will Bussiere

Founders choosing a structure for their business are often drawn to the limited liability company, or LLC, for its overall flexibility in both taxation and governance matters. And founders seeking access to early capital, not to mention seed investors themselves, are often drawn to the convertible note as a simple, less expensive means to raise funds. But LLCs and convertible debt don’t always mix. LLCs are generally treated as partnerships for federal income tax purposes and the rules regarding debt in a partnership are different than that of a corporation.  LLC members should be aware of the risks associated with the issuance of debt instruments and when such debt is repaid, converted, assumed or discharged.

Treatment of LLC Debt for Members

In general, an LLC member’s initial basis in its membership interest is equal to the member’s investment amount or its contributed capital amount. In a pass-through entity like an LLC, all profits and losses flow up to the LLC’s members.  Profits will increase a member’s basis in its interest, while losses or distributions will reduce a member’s basis.  Distributions in excess of a member’s basis are generally taxed as capital gains, which will be treated as long-term capital gains if the member has held its interest for more than a year. 

When an LLC takes on debt, the federal income tax rules provide that a member’s basis in its interest is increased by that member’s share of the debt. In general, a member’s share of an LLC’s debt is determined by that member’s economic interest in the debt or in accordance with the member’s interest in the LLC.  In a simple ownership structure where a member owns 10 percent of an LLC’s outstanding ownership interests, that member will typically see an increase in its basis equal to 10 percent of the total debt incurred by the LLC.  However, a member’s interest in an LLC is often not a simple pro rata calculation.  For example, a member’s share might be increased if the member makes any partial or full guarantees of the debt, is the holder of the debt or has a contractual greater-than-pro rata share of the profits and losses of the LLC.  It is important to note that whatever allocation is required, the full amount of debt incurred by an LLC is always allocated among the members and increases their basis in some manner. 

Repayment and Conversion of LLC Debt

When an LLC’s debt is repaid, the LLC’s members may recognize gain.  This is because a repayment of debt is deemed to be a distribution of cash for federal income tax purposes. That means that if the amount of cash deemed to be distributed to a member exceeds that member’s basis, the member will have a taxable gain.  In certain circumstances, this event could have economically dire consequences for LLC members.

Consider a start-up LLC that funds its operations through the founders’ capital and third-party debt.  The LLC grows its business but is not profitable.  As the growth produces losses, the members’ basis in their interests, including the basis increase received from the debt, is reduced to zero.  Now imagine that an equity investor enters the picture and the new cash from this investor is partially used to repay all of the debt.  This repayment is treated as gain to the members because it is a deemed distribution of cash that exceeds their (now zero) basis in their membership interests. 

In theory, the LLC’s members should be able to use losses previously allocated to them to use to offset the gain; however, this depends on each member’s individual circumstances.  A member that used some of those losses to offset other income will now have a tax bill because the member, funded by the debt, already received the economic benefit of its loss. 

Importantly, the same result occurs if the debt is converted into LLC equity instead of being repaid.  In such a case, conversion of debt into equity is deemed a repayment of the debt, and the LLC’s members would still be treated as receiving a cash distribution in the amount of the “repaid” debt.  If the members have been using their losses to offset other income, the LLC’s seemingly harmless convertible debt may result in taxable gain to the members when such debt is repaid.  Members of debt-financed LLCs could thus find themselves on the hook for significant tax liabilities, particularly if no corresponding cash distribution is made from the LLC to pay those taxes.  

Conversion to C Corporation

Many Series A investors (or later-round investors) will require an LLC to convert itself to a corporation immediately prior to the consummation of the financing round.  The conversion can be accomplished through a state conversion statute by filing a certificate of conversion or the formation of a new corporation and moving the business of the LLC into this new corporation via a merger or some other form of corporate transaction.  For federal income tax purposes, the conversion of an LLC to corporate form, whether by a conversion statute or the actual formation of a new corporation, is generally treated as a new corporation being formed and the LLC being dissolved in some fashion.   As with the examples above, the assumption of the debt by the new corporation (or deemed new corporation) is treated like a repayment of the debt by LLC with the same potential gain and tax liability issues as those with respect to the debt being repaid or converted into LLC equity. 

The conversion of LLC convertible debt into stock of the new corporation (or deemed new corporation) can cause additional problems.  To effect a tax-free conversation of an LLC into a corporation, the LLC’s members and the new investors must hold (in the aggregate) more than 80% of the new corporation’s voting stock and each other class of the corporation’s non-voting stock.  Depending on the form of the conversion and whether they are also LLC members with interests separate from their debt positions, the convertible debt holders may not be counted as part of this group.  This could cause the conversion to be taxable to the LLC’s members.  For this reason, it is important for the LLC’s legal and tax advisors to structure the conversion in a form that results in a tax-free conversion based on the facts and circumstances of a particular entity and its holders. 

Bankruptcy

As mentioned above, an LLC is generally treated as a partnership for federal income tax purposes.  In the event that the LLC becomes insolvent or enters bankruptcy, the holders of the LLC’s convertible debt are likely to be paid nothing and the debt effectively cancelled.  Cancelled debt in an LLC results in the recognition of ordinary income to the members in an amount equal to the cancelled debt.  The normal exclusions from such cancellation of debt income for insolvency and bankruptcy do not apply at the entity level in an LLC like they do in a corporation.  Instead, insolvency and bankruptcy are tested at the level of the beneficial owner.  Any members who are solvent will still recognize cancellation of debt income even though the LLC itself is insolvent or bankrupt.  Without a corresponding amount of losses to offset that gain, each LLC member could be left paying taxes on the income caused by the cancellation of the debt. Hence the members, who likely entered into an insolvency proceeding to avoid burdening themselves with further financial difficulties, can find themselves liable for taxes without receiving anything from the dissolution of the LLC.

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LLC members should consider whether convertible debt is worth the significant risk or expense that can be imposed on the LLC and its members.  LLC members who expect a long-term commitment to the LLC structure and smooth sailing in their business endeavors may be well situated to issue convertible debt.  For many others, including LLCs where a conversion to the corporate form is possible or where a high upside/downside in the business model heightens the risk of insolvency or bankruptcy, a seed round of LLC equity might be the better way to go.