A simple agreement for future equity (SAFE) is a contract between an investor and a company that provides rights to the venture capital investor for equity down the road. Interested clients need to know that, concerning taxes, this relatively new and quick form of raising venture capital is not simple, advisors say.

For starters, “there is no definitive IRS guidance on SAFEs,” said Tom Smitha, tax director at CBIZ MHM in Denver.

“For [venture capitalists], raising or infusing money to support future growth and operations of businesses can often be at the forefront, which is why it’s more important to educate them on the tax planning,” said Matt Kardish, a CPA and manager at Transaction Advisory Services at Stephano Slack in Wayne, Pa.

“Whether investors properly consider the tax consequences vastly differs based on who they are,” added Michele Alexander, a partner at the law firm Barnes & Thornburg in New York. “Venture capital investors and other investors often are pressured to accept ideas marketed at face value.”

SAFEs are typically exchanged for equity or receive proceeds in a liquidity event as if exchanged for equity, at a price per share calculated based on a pre-agreed valuation cap or a discount, said Catherine Turgeon, partner at Barnes & Thornburg.

“The price per share is determined based on a future triggering event, such as a qualified financing, IPO, change of control transaction or other liquidity event,” she said.

SAFE taxes fall under the categories of debt, equity derivative or equity ownership. Each can be tricky to define, and each brings tax consequences, advisors say.

“SAFEs are usually not debt, mostly because there’s no promise of payback and a set interest rate,” Kardish said. “There are also often no voting rights, like some debt instruments may include. There’s also no claim to assets or collateral if the company goes bankrupt [and] generally no right to dividends or the right to share in profits or losses.”

If a partnership issues a SAFE, depending on the facts, the instrument may not be considered stock since the issuing entity may not be “considered a corporation under federal income tax law or state corporate law,” Smitha said.

“Compared to debt, a SAFE typically does not have a repayment obligation, interest accruals, creditor rights or a maturity date,” he said.

Amid such uncertainty, facts should guide the most appropriate tax treatment, advisors say.

“For example, voting rights suggest equity,” Alexander said. “A fixed promise to get back cash or other property besides shares, if receipt of shares is not likely, weighs in favor of debt. There also are types of equity derivatives that are subject to complex tax rules, and SAFEs can mirror those characteristics.”

Smitha said, “For income tax purposes, and depending on the facts, the most appropriate classification for a SAFE may be the equivalent of a prepaid forward contract to purchase equity. ... SAFEs are often economically similar to a prepaid forward contract [where] one party commits to purchase from a counterparty a fixed amount of property at a fixed price on a fixed future date.”

The IRS has provided guidance on the tax treatment of forward contracts. “For income tax purposes, forward contracts are usually treated as ‘open transactions,’” Smitha said, meaning that tax consequences occur when the contract is concluded, not originated, and prepaid amounts don’t alter its general tax treatment.

When classifying as equity ownership, “the caveat is that it is best often structured this way if the parties know that the SAFE would eventually turn into shares,” Kardish said. “Timing is everything—if there’s an imminent possibility of raising money at an actual valuation, this is when the benefit is best. With this type of transaction and equity treatment, the clock starts on the capital gain holding period right away.

“Treating SAFEs as equity is best when there’s a reasonable likelihood that the SAFE will convert to shares in the short term,” he added. “The forward contract can be more advantageous when there is less known about the future valuation and there’s less insight into the business itself.”