To define "stock", regulation 1.382-2T(f)(18) first refers to
1.382?2(a)(3)(i). The pertinent portions of the latter are the
(3) Stock -- (i) _In general._ Except as provided in this
paragraph (a)(3)(i) and §1.382?2T(f)(18)(ii) and (iii),
the term stock means stock other than stock described in
(ii) _Convertible stock._ The term stock includes any convertible
stock. For rules regarding the treatment of certain convertible
stock as an option, see §1.382?4(d)(9)(ii).
GPO Access: Internal Revenue: §1.382-2
Since a convertible note is not the same as a convertible stock, nor is
it actually stock, it is not a stock under this definition.
However, 382-2T(f)(18) goes on to stipulate three conditions under which
an instrument that is not a stock can be treated as stock for the purpose
of §1.382 . All three of these conditions must be fulfilled in order
to treat the non-stock instrument as stock.
(iii) _Treating interests not constituting stock as stock._
Any ownership interest that would not be treated as stock
under paragraph (f)(18)(i) of this section (other than an
option that is subject to paragraph (h)(4) of this section)
shall be treated as constituting stock if --
(A) As of the time of its issuance or transfer to (or by) a
5-percent shareholder (or a person who would be a 5-percent
shareholder if the interest not constituting stock were
treated as stock), such interest offers a potential significant
participation in the growth of the corporation,
(B) Treating the interest as constituting stock would result
in an ownership change, and
(C) The amount of the pre-change losses (determined as if the
testing date were the change date and treating the amount of
any net unrealized built-in loss as a pre-change loss) is more
than twice the amount determined by multiplying
(1) The value of the loss corporation (as determined under
section 382(e)) on the testing date, by
(2) The long-term tax exempt rate (as defined in section 382(f))
for the calendar month in which the testing date occurs.
GPO Access: Internal Revenue: §1.382-2T
Let us consider each of these conditions in turn. According to your
description of the matter, the convertible notes are being distributed
to parties who will then hold a stake in the corporation, which can
eventually be realized in the form of actual stock. It is therefore
true that those who hold the convertible notes will have "potential
significant participation in the growth of the corporation", which is
precisely the purpose of issuing these convertible notes. Furthermore,
you estimate that the notes, when converted into stock, will amount to
at least a 5% share in the corporation. If this estimate is accurate,
then condition (A) has been met.
If the individual, X, who will be holding these convertible notes is
a new owner because he did not previously have such a stake in the
corporation, then his share of the corporation indeed constitutes an
ownership change. This satisfies condition (B). If he is not a new owner
and no ownership change is effected by his receipt of the convertible
notes, then §1.382-2T does not apply at all.
Thus, the question of whether the convertible notes are to be treated
as stock in the sense of §1.382-2T comes down to whether condition
(C) is satisfied. This condition asks us to compare the amount of the
loss corporation's pre-change losses to twice the value of the loss
corporation multiplied by the long-term tax-exempt rate for the month
in which X receives his convertible notes. Condition (C) is fulfilled
if the corporation's pre-change losses are greater than the latter amount.
If X receives the convertible notes in November 2005, for example,
the long-term tax-exempt rate is 4.24% . Twice that rate is 8.48%,
so if the loss corporation's pre-change losses are greater than 8.48%
of the loss corporation's total value, condition (C) has been met and
X's convertible notes shall be treated as stock. Otherwise, condition
(C) has not been met and the convertible notes do not qualify as stock.
To find out the long-term tax-exempt rate for any month up to and
including the current month, click on the particular month at the
Time Value Software: Applicable Federal Rates (AFR)
Once you're on the page for a given month, scroll down to Table III
and consult the entry labeled "Long-term tax-exempt rate for ownership
changes during the current month".
In conclusion, the outcome of a simple calculation will tell you whether
X's convertible notes are to be treated as stock under Section 382 of the
Tax Code. The only values you have to plug in are the loss corporation's
pre-change losses, the value of the loss corporation, and the long-term
tax-exempt rate for the month of the change. Bear in mind that "change"
in this context refers to ownership change, which is the point at which
X takes possession of the convertible notes.