Structuring Secured Notes for Startups and Small Businesses

Tax and Accounting Implications of Secured Notes

Borrower (issuer): Record proceeds as a liability (note payable) at gross cash received. If issuance includes significant noncash consideration (e.g., warrants), allocate proceeds between debt and equity per applicable guidance.
Lender (holder): Record the secured note as a financial asset (note receivable) at the transaction price.

Borrower: Upfront costs (legal, underwriting) are typically capitalized and presented as a deduction from the carrying amount of the liability and amortized over the note’s life (effective interest method). If issued at a discount or premium, amortize to interest expense using the effective interest rate.
Lender: Origination fees and acquisition costs adjust yield and are recognized over life of the asset via effective interest method.

Cash interest: Recognize interest expense (borrower) or interest income (lender) using the stated or effective interest rate.
Imputed interest: If below-market or zero-interest, impute interest based on applicable tax rules and accounting standards; record discount and amortize.
Accruals: Accrue interest consistently (periodically) unless using cash-basis rules for tax reporting where allowed.

Accounting: Collateralization affects disclosures (security, priority, valuations) but typically does not change classification of the debt—still a liability for the borrower and receivable for the lender. If transfer of collateral involves derecognition criteria, evaluate sale vs. secured borrowing accounting models.
Tax: Collateral generally doesn’t create taxable events. However, foreclosure or repossession may trigger tax consequences (gain/loss on disposition, cancellation of indebtedness income if debt discharged).

Lender: Assess expected credit losses (CECL or IFRS 9 expected credit loss model). Consider collateral value and recovery prospects when measuring impairment; incorporate time value and costs to recover.
Borrower: Default risk may trigger remeasurement, renegotiation accounting (modification vs. extinguishment), and possible recognition of gain/loss if terms change materially.

Accounting: If terms change, determine whether modification is substantial (treat as extinguishment) or a modification (prospective adjustment). For substantial modifications, recognize gain/loss on extinguishment.
Tax: Modified terms may create immediate taxable income (e.g., cancellation of indebtedness) unless exceptions apply (insolvency, bankruptcy, qualified real property business indebtedness, etc.).

Borrower: Loss on disposal of collateral measured as difference between carrying amount and proceeds; possible taxable gain/loss implications.
Lender: On repossession, record acquired collateral at fair value less costs to sell or at the loan’s carrying amount if repossession treated as satisfaction of loan under applicable guidance; recognize any shortfall or gain/loss.

Both parties: Disclose material terms: collateral description, covenants, maturity, interest rate, priority, restrictions, and default provisions. Lenders disclose credit risk and collateral valuation methodologies; borrowers disclose debt schedule, maturities, covenants, and any defaults or waivers.

Interest: Deductible by borrower and taxable to lender as interest income, subject to limitations (e.g., interest capitalization rules, net interest expense limitation, related-party rules).
Withholding and reporting: Cross-border interest may be subject to withholding tax; report on applicable information returns (e.g., Form 1099-INT in the U.S.).
Cancellations/foreclosures: Report COD income, gains/losses on disposition, and