Tax treatment of SAFE instruments is not a lock

Various tax issues important to a capital-raising company or its investors can hinge on whether a Simplified Agreement for Future Equity (a SAFE) is treated as equity, debt, or an equity derivative contract for tax purposes. For example, these tax issues may include:

1. Equity holding period determinations, which on sale of the investment, may affect:
   1. Whether the favorable long-term capital gain rate applies
   2. Whether section 1202 may exclude any capital gains from federal income tax
   3. Whether the special carried interest rules of section 1061 apply
2. Section 382 ownership change determinations, which may affect the ability of a corporation to use carryforwards of:
   1. Net operating losses (NOLs);
   2. Tax credits; or
   3. Disallowed business interest expense
3. Application of related party rules, such as section 267(b)
4. Controlled foreign corporation (CFC) ownership determinations
5. Passive foreign investment company (PFIC) ownership determinations
6. Whether a SAFE-issuing company that is not a corporation is classified as a partnership or a disregarded entity

What are SAFEs and how do they work?

Since their introduction by Y Combinator in 2013, numerous early-stage or growth stage companies have used SAFEs to raise funds from investors. To finance their business, start-up companies may prefer SAFEs as an alternative to convertible debt. SAFEs also are typically less complicated than formal equity financing.

SAFEs typically are issued in exchange for cash. Their terms are more favorable to the SAFE-issuing company than those of convertible debt. Unlike convertible debt, SAFEs typically lack a maturity date, a stated interest rate, and default provisions. Repayment rights provided by a SAFE typically apply only upon liquidation of the company and are junior to the rights of all of the company’s debt holders.

Multiple forms for drafting SAFE instruments are available on the Y Combinator website, and many companies use those forms. Some more recently released forms, sometimes called ‘post-money SAFE’ forms use sample terms more similar to equity instruments than the terms of the earlier-released SAFE forms, sometimes called ‘pre-money SAFE’ forms.

A SAFE will automatically convert to equity of the issuing company (e.g., stock) upon certain triggering events, such as an equity financing or a sale of the company. A triggering event generally results in a post-money SAFE converting into a fixed or determinable percentage of the company’s equity that was fixed or determinable at the time the investor purchased the SAFE instrument. A pre-money SAFE holder, on the other hand, typically will receive equity at a discounted price upon triggering event. That is, upon the company’s next sale of equity interests, the pre-money SAFE generally will convert automatically into that class of equity and provide the SAFE holder with that equity at a lower per share (or per unit) price than the cash price paid by the contemporaneous equity buyers of stock. SAFE instruments may use various names for this discount feature, such as “valuation cap,” “valuation ceiling,” or “discount.”

Tax characterization: Variable prepaid forward contract or equity?

The federal income tax treatment of SAFEs is impactful for multiple reasons including those listed above. There are three potential characterizations of a SAFE to consider for federal income tax purposes, namely, treatment of the SAFE as:

1. A debt instrument
2. An equity derivative, typically a variable prepaid forward contract, or
3. An equity instrument.

Determining how a SAFE should be characterized for tax purposes involves weighing the relevant factors in the context of specific facts and circumstances. As an initial matter, SAFEs generally should not be treated as debt because they lack essential indicia of debt, including an unconditional repayment obligation and an interest element. Economically, a SAFE holder can participate in any upside of the growth of the company in the form of a greater amount of stock (or equity) upon a triggering event.¹ In addition, a holder’s right to the return of its original investment is typically subordinate to the rights of creditors.

SAFEs often do not fit neatly within the category of equity. Though SAFEs do have certain liquidation rights, they in many situations are not accompanied by voting rights, dividend rights, and profit and/or loss-sharing rights.²

In those situations, it is often appropriate to treat a SAFE as a forward contract to purchase equity – i.e., a type of equity derivative contract. Under a forward contract, a buyer and seller agree that the seller will sell specified property to the buyer at a future date and at a fixed or variable price. Where the buyer pays at entry into the forward contract, the contract is a prepaid forward contract. Where the amount of property to be conveyed to the buyer is variable or contingent, the contract is a variable prepaid forward contract.

Treating a SAFE as a variable prepaid forward contract often is appropriate. This is particularly true with respect to pre-money SAFEs where the investor pays a specified price up front, and the contract provides for issuance of equity to the investor at a later date with the amount of equity the investor will receive dependent on the company’s valuation at the time of the triggering event.

In some instances, a SAFE may be property treated as equity (e.g., stock) of the issuing company. A post-money SAFE generally is more likely to be viewed as equity for federal income tax purposes than a pre-money SAFE.

Whether treatment of a SAFE as a forward contract or as equity represents the better view may depend on factors such as:

• Likelihood of receiving equity: When the parties enter into the SAFE, how certain is it that an event will occur that causes the SAFE to convert to equity? A letter of intent, agreement (oral or written), or the beginning of significant negotiations to complete an equity financing, business sale, or other triggering event all could make it more likely that the SAFE holder will receive stock (or units).
• Voting power and governance: Does the SAFE holder in fact have voting power in the company, including governance rights, management rights, or the power to elect board of directors, managers, or officers of the company?
• Conversion rights: fixed or contingent: If the conversion rights (which would be triggered by a capital raise, a sale, etc.) are fixed at the time the SAFE contract is purchased, their fixed nature could weigh in favor of equity treatment for tax purposes. If the conversion rights are contingent, how favorable are the terms of the discount or valuation cap to the holder of the SAFE? If significantly favorable, the terms might weigh in favor of equity treatment, especially when coupled with a high likelihood of receiving stock (or units).³

The Importance of SAFE tax characterization

If a SAFE is a prepaid variable forward contract, the company generally is not treated as issuing stock (or other equity) to the holder of the SAFE until (or unless) a triggering event occurs. Only then is the company treated as issuing stock (or other equity) to the holder in exchange for property.⁴ By contrast, if the SAFE is treated as equity at the original purchase date, the investor is treated for tax purposes as holding an equity interest in the company at the initial investment date. This difference in treatment has the potential to impact the SAFE holder in many situations. For example, an investor’s holding period in stock is important in determining whether, when the investor sells its equity interest, the investor should apply the long-term capital gain rates under section 1, the carried interest rules under section 1061, and/or the capital gain exclusion rules under section 1202.

Example 1 – SAFE treated as equity derivative: In Year 1, Investor paid $5 million for a SAFE issued by X, a start-up corporation. The agreement provided that Investor would receive stock of X upon an equity financing event. In Year 2, X raised additional financing via an equity round, and Investor received stock of X as a result. Assume that the SAFE was properly treated as a variable prepaid forward contract for tax purposes, not as stock of X.

Because the SAFE in this example was not stock, Investor does not begin its holding period in X stock until Year 2 in this example—i.e., the 5 years Investor held the SAFE is not included in the stock holding period.⁵ As a result, Investor would not have long-term capital gain on the sale of any X stock until at least Year 3.⁶

The tax characterization of a SAFE can affect whether (or when) a section 382 ownership change occurs. Section 382 limits a corporation’s use of NOLs and certain other tax attributes following an ownership change.

Example 2 – SAFE treated as stock: In Year 1, Investor paid $5 million for a SAFE contract issued by X, a start-up corporation, at the time the stock of X (including the SAFE) was worth a total of $9 million and X had an NOL carryforward of $5 million. The agreement provided that Investor would receive stock of X upon an equity financing event. In Year 2, X raised additional financing via an equity round when the total value of its stock was $36 million, and Investor received stock of X as a result. Assume that the SAFE was properly treated as stock of X for tax purposes.

Because the SAFE in this example was treated as stock, X underwent a section 382 ownership change (i.e., a greater than 50% owner shift)⁷ in Year 1 as a result of its sale of the SAFE. X’s $5 million of NOLs are subject to the section 382 limitation.⁸ Also, the annual limitation (i.e., the amount of section 382-limited NOLs usable each year) is lesser than it would have been if the ownership change did not occur until Year 2, because X total stock value was lower in Year 1 than it was in Year 2.⁹

How does the agreement address tax treatment of the SAFE?

Another question to consider is whether the SAFE agreement addresses the SAFE’s federal income tax treatment. The answer to this question often is “yes.” The boilerplate language of SAFE forms often includes language stating that the SAFE will be treated as stock for federal income tax purposes. Although this boilerplate language may be intended to keep things simple, it can present complications since treatment as stock may or may not be appropriate. For example, the authors have seen instances where entities treated as partnerships for federal income tax purposes include the boilerplate statement that the SAFE is treated as stock for tax purposes. In those instances, the boilerplate language clearly is incorrect because a business entity cannot be treated for federal income tax purposes as issuing stock if it is treated as a partnership (i.e., not as a corporation).

Conclusion

Early-stage companies may benefit from using SAFEs instead of convertible debt to finance their operations. A SAFE’s characterization for tax purposes is important to the company and its investors but is not always clear-cut. Capital-raising companies and their investors should consult their tax advisors and consider the potential tax impacts prior to entering into SAFE instrument.

¹ See, e.g., FSA 199940007, supplemented by FSA 200131015 (instrument with a payment at maturity determined solely by reference to value of equity was not debt).

² See, e.g., Rev. Rul. 2003-7, 2003-5 I.R.B. 363 (a shareholder that receives a fixed amount of cash and simultaneously enters into an agreement to deliver a number of shares that is variable depending upon future value treated neither as selling stock under section 1001 nor constructively selling stock under section 1259).

³ See, e.g., Rev. Rul. 82-150 (deep in the money stock option treated as stock).

⁴ See, e.g., Rev. Rul. 2003-7; CCA 201025047 (Mar. 22, 2010) (confirming that in PLR 200450016 (Aug. 17, 2004), corporation recognized no gain or loss under section 1032(a) on the issuance of its own stock in settlement of a forward contract).

⁵ Section 1223(5).

⁶ Section 1222(3).

⁷ Section 382(g)(1).

⁸ Section 382(a)(1).

⁹ Section 382(b)(1).