Tax Implications of SAFE
(Simple Agreement for Future Equity) Investment

SAFEs (Simple Agreement for Future Equity) are a type of financing instrument used mostly by startup companies. A SAFE is considered a prepaid equity instrument, allowing investors to purchase equity in the future at a discounted price.

For tax purposes SAFEs can have various tax implications.

Tax Implications of Utilizing a SAFE

The tax implications of utilizing a SAFE (Simple Agreement for Future Equity) investment are as follows:

SAFEs Treated as Forward Contracts – SAFEs can be treated as a contract that lets you buy part of the company later – a forward contract. You pay now for a future right and get shares later when a transaction occurs, such as a qualified financing or liquidity event. The number of shares you receive depends on the company’s valuation at that time. There are no immediate tax consequences for the company or the investor when initially issuing a SAFE. The later issuance of shares to fulfill the SAFE contract is also tax-free.

SAFES Treated as Equity – An alternative tax treatment would be to treat the SAFE as an equity grant, owning part of the company (shares of stock) for tax purposes. If you pay for the SAFE and treat it as equity of the company, then the capital gain holding period will begin the day you bought the SAFE, which can result in a tax benefit depending on when there is a realization event for the shares.

Determining the Tax Implications –  To determine the tax implications, one must look at the facts and circumstances of the specific situation. The likelihood that the SAFE will convert to shares, the control the investor has over the company, and the rights the investor has are all factors that affect the tax implications.

Tax Benefits – The tax implications can result in tax benefits such as long-term capital gains rates and qualified small business stock (QSBS) tax exclusion. Starting the holding period earlier can result in a major tax boon for investors in some cases.  Click on following link to find out more about QSBS

Tax compliance – Companies that issue SAFEs are also responsible for reporting details of each transaction (and the resulting tax liability) to relevant tax authorities such as the IRS. Neglecting tax compliance can lead to issues and potential penalties that make it more difficult for your business to grow.

Potential Tax Issues by IRS Code Section

Here’s a brief overview of the potential tax issues attached to SAFEs under a variety of IRS code sections:

  1. Section 1202 Qualified Small Business Stock (QSBS) – SAFEs may not qualify as QSBS, which could limit the availability of the 100% exclusion from gross income for gain on the sale of QSBS, held for at least five years.
  2. Section 1045 Rollover of Gain on Sale of QSBS – If a SAFE investor sells their SAFE and reinvests the proceeds into a new QSBS within 60 days, they may be able to roll over the gain, deferring tax on the gain.
  3. Section 83 – Property Transferred in Connection with Performance of Services – If a SAFE is granted as compensation for services, Section 83 may apply, requiring the recipient to recognize income based on the fair market value of the SAFE.
  4. Section 368 – Corporate Reorganizations – If a SAFE converts into equity as part of a corporate reorganization (e.g., merger or acquisition), Section 368 may apply, allowing for tax-free treatment of the conversion.
  5. SAFE vs Convertible Debt

A SAFE and convertible debt instrument are both financing structures used by startups, but they have different tax treatments.

A SAFE is considered a prepaid equity instrument, allowing investors to purchase equity in the future at a discounted price.

For tax purposes:

  • No interest expense is deductible by the company since SAFEs have no interest charges in most
  • SAFE agreements.
  • No interest income is taxable to the investor for the above reasons.
  • Upon conversion to equity, there is no taxable gain or loss

Convertible debt, on the other hand, is a loan that converts to equity in the future.

For tax purposes:

  • The company can deduct interest expense on the debt.
  • The investor must recognize interest income.
  • Upon conversion to equity, the company may recognize a taxable gain or loss (depending on the conversion price and the debt’s face value).

In summary, a SAFE is treated as a prepaid equity instrument for tax purposes, while convertible debt is treated as debt until conversion. This difference in tax treatment can impact the company’s and investors’ tax liabilities and financial reporting.

Keep in mind that tax laws and regulations can change, and specific circumstances may affect the tax treatment. Consulting a tax professional or financial advisor is recommended for precise guidance.

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The information presented here should not be construed as legal, tax, accounting, or valuation advice. No one should act on such information without appropriate professional advice and after a thorough examination of the particular situation