A startup needs $500K but is still an LLC. An investor offers either a convertible note or a SAFE. The wrong choice can trigger a six-figure tax bill with no cash to pay it.
TL;DR - Your Quick Answer
- LLCs + Convertible Notes = Potential cancellation of debt (COD) income tax trap
- LLCs + SAFEs = Most likely there will be fewer tax problems, though there is no formal IRS guidance
- Best path: Convert to a C-Corp before raising any convertible instruments
- If staying an LLC: a SAFE is generally safer than a convertible note
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Is this article for you?
Read this if:
- For LLC founders weighing a SAFE vs. a convertible note
- Not yet converted to a C corporation
- Aiming to avoid tax surprises on conversion
Quick definitions:
- Convertible note: Debt that may convert to equity; has interest and a maturity date.
- SAFE: Contract for future equity; not debt; no interest or maturity date.
Skip if organized as a C-Corp.
Next: Convertible note tax risks for LLC founders.
Convertible Note Tax Risks When Founders Raise Through an LLC
A note is debt. When it converts to LLC units, the tax rules can create taxable income to existing members in two ways.
Trap One: Cancellation of Debt Income
When an LLC satisfies debt by issuing units, the tax rules compare the amount owed to the fair market value of the units issued at that moment. If the units are worth less than the debt, the difference is cancellation of debt (COD) income allocated to the existing members, not the converting investor (Treas. Reg. §1.108-8).
Example: An LLC owes $1,000,000 on a note. At conversion, an independent valuation indicates the new units are worth $700,000. The LLC recognizes $300,000 of COD income allocated to existing members on their K-1s. Two equal founders each report $150,000 of taxable income despite receiving no cash.
Trap Two: Hidden Tax from Using Losses Against Other Income
This trap catches founders who used LLC operating losses to reduce taxes on other income. Those losses reduce basis, which creates a problem when convertible debt converts.
Here’s the mechanism: When an LLC issues a convertible note, partnership tax rules allocate that liability to members, increasing their tax basis. If the LLC then generates operating losses, members can use those losses to offset income from other sources—salary, investment income, or other businesses, reducing their current-year taxes. Those losses reduce the member’s basis in the LLC.
The problem surfaces at conversion. When the note converts to equity, the debt disappears. Partnership tax rules treat the reduction in liabilities as a deemed cash distribution to each member. If a member’s basis is too low, because they already used losses to offset other income, that deemed distribution triggers taxable gain, even though no actual cash changes hands and even if there’s no debt forgiveness.
Members get a tax benefit from using losses against other income. Years later, when the note converts, they pay tax on gain with no cash to pay it. The gain essentially recaptures part of the earlier tax benefit. This basis problem can surface in other contexts, distributions, sales of LLC interests, or other liability reductions, but the convertible note scenario is particularly problematic because founders rarely anticipate that raising money will trigger a tax bill.
Real Example: How Founders Get Burned
Mechanically: The note increases basis via partnership liability allocations; when the liability goes away at conversion, partnership rules treat the decrease as a distribution, and gain can be triggered if basis is insufficient (IRC §§ 752, 731).
Red flag: LLCs with operating losses and pending convertible debt conversions face high risk of COD income or basis-drop gain, engage tax counsel before triggering conversion. These debt conversion tax problems can arise through other scenarios as well, not just when members have used losses to offset other income.
Real Example: How Founders Get Burned
Notes are rarely ideal for LLCs; they only fit when repayment is realistic or conversion will be actively managed by tax counsel.
Use a note only when cash repayment before conversion is realistic or when tax counsel will actively manage the conversion mechanics. Consider a note if:
- the investor expects a near-term cash repayment and the company has a credible path to generate that cash; or
- the note will bridge only a short window before conversion to a C-Corp and a priced round closes.
If neither condition fits, prefer a SAFE or convert to a C-Corp before raising to avoid surprise COD income or basis-driven gain.
Are SAFEs actually safer for founders running LLCs?
Founders raising through an LLC generally encounter fewer surprise tax bills with SAFEs because the instrument is not debt, so the COD and basis-drop traps that plague notes do not automatically trigger. That makes SAFEs the go-to instrument when conversion to a C-Corp before raising is not feasible.
As of October 2025, there is still no published IRS guidance specifically addressing SAFEs issued by LLCs. However, based on discussions with tax attorneys at major firms, there is no observed pattern of IRS challenges to properly structured LLC SAFEs over the past five years.
SAFEs have no interest or maturity date and convert into equity when a future priced financing occurs. There is no published IRS guidance directly on point. In practice, well-drafted LLC SAFEs have not produced a pattern of enforcement problems. That’s a market signal, not a legal guarantee.
Why practitioners prefer SAFEs over notes in an LLC: a properly drafted SAFE is not debt, so the specific debt-for-equity COD problem that plagues notes does not arise. Drafting must still protect that status.
Guardrails for an LLC SAFE
- Keep the holder out of member status until conversion. This means no voting, no distributions, no K-1.
- Avoid debt-like features (no fixed return, no mandatory cash repayment by date; avoid redemption or mandatory cash-out features that risk debt characterization).
- Focus the instrument on conversion into LLC units upon a priced financing.
Quick Decision Framework
When to Get Tax Counsel Involved
Get tax counsel before proceeding if:
- The LLC has operating losses that reduced member basis.
- Convertible debt is outstanding and a financing is approaching.
- Considering convertible instruments where total debt will exceed capital contributions.
Cost expectation: Tax counsel review for LLC convertible instruments typically runs $3,000 to $10,000, depending on complexity. That’s a fraction of the potential tax liability from getting it wrong.
Market Reality
Despite theoretical tax advantages of LLCs, VC-backed startups overwhelmingly organize as C-Corps. Founders planning an institutional fundraising path should convert to a C-Corp before raising money. If remaining an LLC, SAFEs generally appear safer than notes based on tax structure and practical experience. If a convertible note is proposed for an LLC, ensure the traps are understood and there is a plan to manage them.
Key Terms Defined
COD (Cancellation of Debt) Income: Taxable income created when a debt obligation is satisfied for less than the amount owed. In LLC conversions, this income is allocated to existing members even though no cash is received.
Basis: A member’s tax basis represents their investment in the LLC, adjusted for contributions, distributions, income, and losses. When basis is too low and liabilities drop, taxable gain can be triggered.
K-1 (Schedule K-1): The tax form an LLC issues to each member reporting their share of the LLC’s income, deductions, and credits. Members report K-1 amounts on their personal tax returns.
Deemed Distribution: Under partnership tax rules, when an LLC’s liabilities decrease (such as when a convertible note converts to equity), members are treated as receiving a cash distribution for tax purposes, even though no actual cash changes hands.
FAQ: Common Questions About LLC Fundraising
Why are convertible notes considered more secure than SAFEs for some investors?
Is a SAFE a security for LLC purposes?
What happens to my SAFE if we never convert to a C corporation?
Most SAFEs contemplate conversion to C-Corp equity. If the company remains an LLC, the SAFE typically converts to LLC units at the next priced financing. Ensure the SAFE explicitly addresses this scenario. Some investors may require amendment or refuse to convert to LLC units, preferring to wait for C-Corp conversion.
Can an LLC issue a SAFE agreement legally?
How can I avoid COD income on convertible note conversion?
Three main strategies: (1) Ensure the conversion happens when the company’s valuation exceeds the note amount, (2) structure as a cash repayment followed by equity investment rather than direct conversion, or (3) convert to a C-Corp before the note converts. All require careful tax planning and likely active management by tax counsel during the transaction. If pursuing “repay then invest,” ensure the cash flows are real (not circular) and consider interest and OID consequences.
⚠️ Critical Point: An LLC can legally issue SAFEs, but the tax treatment remains uncertain without IRS guidance. This is a risk-tolerance decision. When in doubt, convert to a C-Corp first or get specialized tax counsel.
Authorities (selected):
- Reg. §1.108‑8 (COD where a partnership issues equity)
- IRC §752; Treas. Reg. §1.752‑3 (liability allocation rules)
- IRC §731 (distributions and gain recognition)
