“Never invest in anything that eats or needs repairing.” – Billy Rose
Putting Section 1202 QSBS (i.e. qualified small business stock) and convertible note (“QSBS Convertible Note”) in the same sentence is a recipe for an “investment needing repaired”. If you have stumbled upon this page there are probably two scenarios for your situation: 1. you have a convertible note and either just heard about the great QSBS or are wondering whether your stock qualifies and/or 2. you are wondering if a potential convertible note investment will qualify as QSBS.
The short answer to both scenarios is NO a convertible note does not qualify for QSBS… yet. A convertible note is considered debt security, regardless if it is accruing interest. To qualify for QSBS the acquisition must be newly issued stock purchased directly from the QSBS company. There is no stock with a convertible note until it converts.
The problem with the convertible note and QSBS is that the QSBS 5-year timeline does not start until the note converts, which generally takes 2 years. Convertible notes can also be a hassle to keep up with as well as calculate what the conversion is and what your basis is for QSBS. If you want to maximize your ROI through tax savings it is probably best to invest directly in the company’s equity pool rather than a convertible note. Eventually, the note will qualify but your QSBS timeline could be a total of 7 years instead of 5.
This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.