One of the extraordinary things about parenthood is our willingness to help our children. We as parents will undergo amazing hardships to help make their lives better, so they don’t suffer as we feel that we did.
Unlike many parents, my father and mother felt very differently about life’s hardships. They believed the trials and tribulations of life were a benefit to children – making them stronger and smarter. They felt the extraordinary efforts parents made to lessen these hardships were actually for the benefit of the parents – not wanting to see their kids suffer – and not for the benefit of the children who need to and benefit from suffering.
As a federal tax attorney for over 35 years, I have seen countless clients who have provided money to children to start up or continue businesses, almost all of which have all failed. And then the IRS gets involved and there’s trouble all around.
So today I want to discuss how to help kids financially without subjecting ourselves to IRS audit risks:
The facts are almost always the same – a child will want to start a new business. They need startup money and they may also need operating capital. Often the best place, perhaps the only place to find money, is their parents. And so the parents advance them money – sometimes a substantial initial advance and often times additional advances to cover losses in early years.
And then, as happens with many new start-ups, the business fails.
1. Personal Loans
If the money was a personal loan, it is just that – personal. If the business fails and the child cannot repay, there is no tax deduction – period.
2. Business Loans
If the money was a business loan, the federal tax law allows lenders to deduct losses on loans that become worthless. Sometimes these losses can be ordinary business losses, sometimes they are capital (investment type) losses.
But when loans are made to children or their businesses, the IRS will carefully scrutinize those advances and try to reclassify them as nondeductible personal loans (this can be especially true if the parents are also made shareholders in the business – the IRS recasting the “loan” as a contribution to the corporation). In fact, the federal tax law contains a presumption that an advance between family members is a gift and not a true deductible loan. I read a new case just last week wherein the United States Tax Court upheld the IRS’s re-characterization of a loan to a gift, and the loss therefrom became a nondeductible personal loss on a gift.
If you intend to advance money to or for your children’s business, there are a couple of things to remember:
It is important that all business formalities be carefully documented. This means there should be a promissory note executed by the business, approved by the Board of Directors, bearing interest and secured by some kind of reasonable collateral. There should be a schedule for repayment of principal and interest, and those repayments should actually be made.
In addition to these formalities, it is important to document that the parties intended to create a loan and not make a gift. We do this by documenting supporting facts, such as why there is a reasonable prospect of repaying the loan, the parents are in need of the money for their support, etc.
So if you are audited by the IRS and have made loans to or for your children’s business, you can count on that loan being carefully scrutinized and recast as personal and not business. Don’t let this happen, take advantage of the possible deduction allowed by the tax law and deprive the IRS of yet another joy in their pitiful bureaucratic lives.
And one last thing. Although I certainly didn’t appreciate it as a young person, I now appreciate the hardships of life that my parents allowed me to face. They trained me well for a lifetime of dealing with the IRS!