Have you ever considered bankrolling your adult child’s business? Many young entrepreneurs seek parental assistance in launching their companies, especially if they encounter difficulty securing bank loans due to a lack of credit history or collateral. And, on their part, many parents want to help their children succeed in starting independent businesses. Although many parent-child loans go smoothly, if a loan does sour it can have serious consequences for unsuspecting parents. Here are some things to consider when lending funds for your child’s business venture:
Document the Loan. It may be appropriate for some parents to treat a business loan as seriously as a banker would, and require proper documentation. If you seal the deal with a handshake, and the business later fails, you must be able to convince the Internal Revenue Service (IRS) you made a bona fide loan in order to deduct it as a bad debt. To give yourself a basis for a tax write-off, require the following documentation:
- loan agreement;
- collateral or other form of security;
- a repayment schedule;
- repayment records;
- a business plan indicating the loan will be repaid as scheduled; and
- proof the business was solvent when the loan was made
Proper documentation can also help you avoid other complications. For instance, if your child were to divorce, a written loan agreement identifying who is responsible for repayment, and on what terms, could prevent a former spouse from refusing responsibility for the debt or claiming the money was a gift. It could also keep an ex-spouse from obtaining—through the division of marital assets¾a controlling interest in a company you funded.
Know the Rules. The IRS allows you to deduct bad debts only if you have first tried to collect them. You may write it off as a short-term capital loss (provided you can document attempts to collect through legal action) by subtracting the outstanding loan balance from your total short- and long-term capital gains for the year. If the loss exceeds your total capital gains, you may deduct it in $3,000 increments each year until it is entirely written off.
Parents also have the option of treating the bad debt as a gift. The IRS currently allows each taxpayer to give up to $15,000 per year (for 2021), to as many people as he or she wishes, free of gift and estate taxes. Thus, both parents could offset an uncollectable debt with a combined gift of up to $30,000 per year with no tax consequences. Any amount exceeding this limit may be subject to gift and estate taxes.
Supporting your child’s business venture can be an exciting and rewarding experience. However, consider tax traps and legal pitfalls before opening your checkbook.
This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
This article was prepared by Liberty Publishing, Inc.
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