For founders of new businesses, having a new investor can seem like a path to greater success, an affirmation of their business model, or a lifeline through a difficult period. But convertible debt and other forms of investment, such as simple agreements for future equity (SAFEs), come with dangerous traps for owners of limited liability companies and partnerships. The most inexperienced of these owners are getting snared by these traps, and business lawyers need to consider how to ensure that business owners enter these arrangements with open eyes.

To understand how the trap is set, a brief refresher in partnership and corporate tax law, as well as tax law regarding debt, is required. First, in almost all circumstances, borrowing money does not result in recognizing taxable income. Instead, it is the forgiveness of indebtedness that results in the borrower recognizing taxable income, unless one of a number of specific exceptions applies.