The Pitfalls of Issuing Convertible Instruments Through an LLC: A Founder’s Guide

Founders often form an LLC and raise their initial capital through convertible notes and Simple Agreements for Future Equity (SAFEs).  Many non US founders are frequently unsure if their holding company will ultimately be Delaware  C-Corp or the Cayman/LLC Sandwich.  By launching with an LLC, the members/owners of the LLC can enjoy nice personal tax deductions for the losses that the LLC inevitably will generate as it launches.   These founders often don’t realize that they could be looking at a large personal tax bill were the LLC to fail before the convertible debt converts to equity.  

 At PAG.Law we’ve seen it all—we advise over 100 bright-eyed Latin founders every year, many of whom are just launching their businesses. Recently, as the market for venture capital has constricted, we’ve had to save several founders from a tax nightmare after they raised convertible notes through their LLCs. 

Why? LLCs are pass-through entities for tax purposes, which means that profits and losses flow straight to the members/owners. Debt-like instruments in an LLC can create “phantom income” for the members/owners of an LLC were it fail before those convertible notes or SAFEs convert to equity. 

If the LLC fails and the outstanding convertible notes aren’t paid back, the forgiven debt becomes taxable income for the LLC members. Thanks to the 80% Net Operating Loss (NOL) limitation, members can only use NOL carryforwards to offset up to 80% of that taxable income. This means that the members/owners of the LLC have to pick up 20% of the forgiven debt as taxable income. 

So, if an LLC had issued $1mm of convertible notes, the members/owners would pick up $200,000 of “phantom income”. That translates to tens of thousands of dollars in income taxes needing to be paid by the members/owners of the LLCs that failed before the convertible notes were converted. The technical term for this is a “nightmare”.  Imagine owing taxes on money you never actually received. It’s like being charged for a meal you didn’t eat at a restaurant that burned down.

Before you say “Well, I am not a US tax resident so why do I care about this “phantom income”, keep in mind the following.  It is correct that non-resident aliens (NRAs) are only subject to U.S. tax on income that is effectively connected with a U.S. trade or business (ECI). However the forgiven debt from an LLC operating in the U.S. would generally be considered ECI, making it taxable for the non-U.S. members/owners.

If the LLC issued convertible notes, there is very little to be done. So what if the LLC issued SAFEs instead of convertible notes?  We just might be able to avoid this result, if we educate the LLCs accountant.  SAFEs unlike their cousin the convertible note are easier to categorize as “contingent equity” rather than “debt” on the balance sheet.. And in the world of LLC taxation, that’s like finding a unicorn in your backyard. No debt, no debt forgiveness, and no surprise taxable income. 

So, instead of being hit with a tax bill after your startup dreams crash and burn, you might dodge that bullet with a SAFE. For owners of LLCs, especially when things go south, this distinction can be a lifesaver. 

So, what’s a savvy founder to do?  First,  founders should avoid issuing convertible notes through their LLCs.  

Second, founders need to ensure that the SAFEs are listed on the balance sheet as contingent equity and not sitting on the balance sheet as debt.   

Third, before the LLC issues any SAFEs, make sure your CPA is on board with treating those SAFEs as contingent equity. It’s not about structuring the SAFE itself—these are standard forms, after all. It’s about educating your financial team on how to treat them. 

 We’ve found that most CPAs are open to a little education about treating SAFEs as contingent equity. It’s like teaching your abuela to use WhatsApp—it takes some patience, but once they get it, they’re all in. 

 At PAG, we’ve seen founders turn their dreams into reality, and we’ve seen others crash and burn.  The difference often comes down to understanding these nitty-gritty details that no one tells you about in your shiny accelerator program. 

 Stay savvy, and stay solvent.  And let’s avoid “phantom income” at all costs.

- Juan Pablo

 Juan Pablo Cappello was a partner in Patagon.com the first fintech in LatAm before being sold to Banco Santander, he is a cofounder of the PAG Law, LAB Miami and Miami Angels and can be reached at jp@pag.law . 

This article is not meant to provide legal or tax advice. It should be understood as a provocative, simplified overview to allow the reader to better consult its legal and tax advisors. Every individual, every company, and every situation is different.  There is no “one size fits all” solution. Also, we are not tax advisors or tax experts and do not offer tax advice. Readers are advised to seek professional advice before acting on any information contained in this article. The author and publisher are not liable for any damages or negative consequences arising from any use of the information presented in this article.