Loaning Money to Your Adult Child to Start a Business

This post originally appeared on Forbes.

Photo credit: www.gotcredit.com
Photo credit: www.gotcredit.com

Recently, I met with a couple who’d lent a substantial sum of money to their adult children to help them start a business. The business failed and the parents wondered if it would be possible to claim a loss on their tax return. Unfortunately, the family had made a few mistakes in handling the loan, resulting in the loan looking more like a gift.

Adult children turning to the Bank of Mom and Dad is not unusual. According to a 2015 Pew Research study, about six out of ten U.S. parents with adult children say they’ve helped an adult child financially in the past year. If you are considering financially assisting your adult children to become entrepreneurs, there are a few things you need to handle up front.

Don’t Give More Than You Can Afford

Before you write a check, make sure you are comfortable with the idea of never seeing that money again. According to U.S. Census data, about half of all businesses started in the United States are around for five years or less. If you are in debt or don’t have enough in savings, don’t cause further stress to your financial situation by making a loan that has a 50/50 chance of being repaid in the best circumstances.

Get It In Writing

The main mistake my clients made was having no formal loan agreement for the amounts loaned to their children. If you are loaning money to anyone, always draw up a loan agreement documenting the amount loaned, a fixed repayment schedule and interest rate.

While the IRS isn’t concerned with small personal loans, if you loan a significant amount of money to your kids you must charge interest. If you don’t, the IRS may determine that the amount you loaned and the interest that you should have charged was a gift. The rate of interest on the loan must be at least as high as the minimum interest rates set by the IRS.

If the total gifted in any one year is greater than the gift exclusion amount of $14,000 (or $28,000 from a couple), you are required to file a gift tax return. Unless you’ve given gifts exceeding the $5.25 million lifetime exclusion from gift tax, you won’t have to pay tax or penalties for late filing, but if you die and the IRS performs an estate tax audit, they can question and tax any gifts you made years earlier if you didn’t file a gift tax return to report them.

If the business fails and your child cannot repay the loan, you may be able to claim a bad debt deduction on your tax return but the IRS tends to scrutinize bad debt deductions for loans to family members. If you cannot prove that a bona fide debt exists, the loan will be treated as a gift and the deduction will be disallowed.

Having a written loan agreement and reasonable rate of interest will go a long way towards establishing the debt is bona fide.You’ll also need to be able to show that you took reasonable steps to collect on the loan. It’s not necessary to take your child to court to show that the debt is uncollectible. At a minimum, you should make a formal request in writing demanding payment and have your child sign a statement asserting that he or she cannot repay the debt, along with a good reason as to why not. If your child is willing and able to make payments on the debt, you cannot write it off as worthless. Partial write-offs of nonbusiness bad debts are not allowed.

Loans between family members are considered a nonbusiness bad debt and treated as a short-term capital loss. Capital losses are deductible only against capital gains, then against up to $3,000 of ordinary income each year. If you don’t have other capital gains, it could take several years to fully deduct the bad debt.

Consider Purchasing a Stake in the Company Instead

Rather than giving a loan that may not be repaid, consider purchasing a stake in the business instead. You might even consider investing in phases, contingent upon the business’ profitability. This type of funding can help your child learn discipline and and keep you from losing large sums of money.

If you purchase a share of the business, this arrangement should be documented in writing, either in a partnership agreement or the organizational documents. If your child is concerned about sharing management of the company, the agreement can be structured to name the parents as silent partners. If the business fails, you can take a loss on your investment. If the business succeeds, you can sell or gift your interest in the business back to your child.

Consider Calling It a Gift

If signed agreements and interest rates aren’t your cup of tea, consider giving your child a gift instead. If you keep the amount gifted under the annual gift exclusion amount, you won’t have to deal with a gift tax return and, if the business goes under, conversations around the Thanksgiving dinner table won’t be strained.

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Health Insurance for The Self Employed

This post originally appeared on Forbes.

 

HealthCare.gov Stock imagery
HealthCare.gov Stock imagery

 

With the deadline for enrolling in a 2016 insurance plan through the Health Insurance Marketplace looming, I’ve heard from many of my self-employed clients and friends that are facing huge rate increases this year. A study by the Henry J Kaiser Family Foundation Many noted that 48% of uninsured adults cite cost as the main reason they are still uninsured. Some self-employed people are choosing to go without health insurance because the penalty going without coverage is still less than annual premiums.

Foregoing health insurance coverage is not a decision I endorse. For 2016, the penalty for not having health insurance is the higher of 2.5% of your household income (with a maximum of the total yearly premium for the national average price of a Bronze plan sold through the Marketplace) or $695 per adult plus $347.50 per child under 18 (with a maximum of $2,085 per year). For 2017 and beyond, the percentage option will remain at 2.5%, but the flat fee will be adjusted for inflation. There are certain exemptions that may help you avoid the penalty.

According to the same Kaiser study, nearly 36% of low- and middle-income uninsured adults said they had problems paying medical bills. At some point, almost everyone is going to need some sort of medical care and medical bills are the single largest cause of consumer bankruptcy. If you are under 30 years old OR are granted a hardship exemption, you can purchase a catastrophic health plan through the Marketplace, no matter your income level. A catastrophic health plan doesn’t cover any benefits other than three primary care visits per year before the plan’s deductible is met. The monthly premium is lower than standard plans, but the out-of-pocket costs for deductibles, copayments, and coinsurance is higher. These types of plans can protect you in the event of some major medical calamity.

Self-employed people have an advantage over employed people who are not covered by an employer group plan. Employees who aren’t covered by their employer’s group plan and have to purchase their own insurance may be able to receive an itemized deduction on Schedule A if their total out-of-pocket medical premiums exceed 10% of their Adjusted Gross Income (AGI) and they have enough other itemized deductions to exceed the standard deduction. Few people are able to meet both of those hurdles.

Self-employed people, however, may be able to deduct health insurance premiums on Line 29 of Form 1040, an “above-the-line” deduction. In order to get an above-the-line deduction, you must report a profit from your business on Schedule C (or have self-employment income from a passthrough entity or farm). If you have some self-employment income, but not enough to cover your health insurance premiums, you can deduct enough premiums to bring your income on Sch C to zero, then report the remainder as an itemized deduction on Schedule A, where you may or may not get a benefit.

If you are married and have the option of getting coverage under your spouse’s employer subsidized health plan, you won’t be able to take your health insurance premiums as an above-the-line deduction. You’ll only be able to claim them on Schedule A.

Some people are still not convinced. Why pay several hundred dollars per year for health insurance coverage with such large deductibles that they wind up paying all of their medical bills out-of-pocket anyway? Because you may be able to save on your taxes AND stash away more money for retirement if you purchase a health insurance plan that is eligible for a Health Savings Account (HSA). An HSA allows you to set aside set aside money to pay for current health care expenses and save for those in the future. For 2016, you can contribute $3,350 per year to an HSA for an individual or $6,750 for a family. If you’re over age 55, you can contribute an extra $1,000 per year. HSA contributions are another above-the-line deduction, reported on Line 25 of Form 1040. Interest earned on the account is tax-free and you can make tax-free withdrawals for qualified medical expenses.

Many people confuse HSAs with health care flexible spending accounts (FSAs), which have use-it-or-lose-it rules. HSAs have no limits on carryovers or when the funds may be used. If you need to use your HSA funds to reimburse yourself for out-of-pocket medical expenses, you can do so. If you don’t need the money, you can leave it there and it can act as another vehicle for retirement savings.

Think of your HSA like a Roth IRA, but better. You can enjoy the benefits of tax-free growth, but you also get the benefit of a current tax deduction. Chances are your medical expenses are going to be higher in retirement than they are right now. Even if you are enrolled in Medicare after age 65, there are still out-of-pocket medical expenses as well as premiums for Medicare Part B.

Before age 65, you’ll face a 20% penalty for withdrawal of HSA funds for nonqualified medical expenses. Starting at age 65, you can make penalty-free distributions for any reason, though you’ll still pay tax on the account’s earnings for any withdrawals that aren’t for qualified medical expenses.

It’s worth noting that the Marketplace is not the only option for shopping for health insurance. You’ll have to use the Marketplace if you want to qualify for premium tax credits, but if your income is too high to qualify for subsidies, you may be able to shop around online or with the help of a broker.

The deadline to enroll in a 2016 insurance plan through the Marketplace is January 31, 2016 for coverage to take effect March 1, 2016.

How to Fill Out the FAFSA

This post originally appeared on Forbes.

Autumn may seem like a long way away right now, but if your child is headed to college this year, now is the time complete the Free Application for Federal Student Aid (FAFSA). The 2016-2017 FAFSA became available on January 1. Completing the FAFSA is not a simple task. It will take some time to gather all of the necessary information, so get started as soon as possible. The due date to submit the FAFSA for the 2016-2017 school year is generally June 30, 2016, although some schools have earlier deadlines.

Although completing the FAFSA is technically the student’s responsibility, parents play a large part if the child is considered a dependent student. Dependency guidelines for the FAFSA are different from those of the IRS. You can’t choose not to claim your child as a dependent on your tax return in order to get a better financial aid offer.

fafsa

Before you begin, make sure you’re applying on the correct site. The official FAFSA website is fafsa.gov and completing the FAFSA is always free. There are many services available online that charge a fee to help you file online. If you are asked to provide credit card information, you are on the wrong site.

One parent and the child will need to apply for FSA IDs in order to log in and sign the FAFSA online. Create the IDs as soon as possible, since you may need to wait up to three days to use your FSA ID after registering. You’ll also need the social security numbers of both parents and the student and the student’s driver’s license number. If the child comes from a single-parent home and lived with one parent the whole year, only the custodial parent will need to provide information.

You’ll need income records for the tax year prior to the academic year for which you are applying, so for the 2016-2017 FAFSA, you’ll need your 2015 tax return. If you haven’t filed your taxes yet, you can still fill out the FAFSA now, estimating 2015 amounts using your 2014 return, and update the FAFSA once you file your 2015 taxes. After you file, you may be able to import your tax information electronically into the FAFSA using the IRS Data Retrieval Tool. Don’t wait until you file your tax return! Financial aid is awarded on a first-come, first-served basis so it’s important to apply early.

You’ll also need records of untaxed income (such as child support, veterans noneducation benefits, and amounts paid to IRAs), balances in all asset accounts (savings and checking account balances, investment accounts, and real estate), and a list of schools the student is interested in attending.

There are a few tricks to improving your eligibility. First, if your family has had a sudden decrease in income, such as a job loss, that isn’t reflected in your 2015 tax information, gather documentation of the situation. Your child will need to present that information to the financial aid administrator at the school. Next, the FAFSA asks how much cash students and parents have in savings and checking accounts at the moment you are filling out the FAFSA but it doesn’t ask about debts or bills. If you have significant cash balances, use it to pay down credit cards, car loans, or other bills before completing the FAFSA. Finally, when listing the value of investments and real estate, don’t make the mistake of including the value of retirement plans and your primary home. Neither is used to calculate financial need, so including them can hurt your chances.

Two-thirds of freshmen FAFSA applicants list only one college on their application, but you should list any school being considered, even if the student hasn’t applied or been accepted yet. All schools listed on the FAFSA will automatically receive your FAFSA results electronically and use that information to determine the types and amounts of financial aid you may receive. You can list up to 10 schools on your FAFSA. If you’re applying to more than 10 schools, you can add more later. Note that some states require you to list schools in a particular order to be considered for state aid. For instance, you might be required to list an eligible in-state college to be considered for state grant aid. Check your state’s requirements prior to filling out that section.

Once you submit the completed FAFSA, it will take about three days for the FAFSA to be processed and sent to the schools, then both you and your child will receive an email confirmation. During the winter or spring, your child will receive financial aid offers from schools.

Complete the FAFSA even if you think you make too much money to be considered for student aid. The FAFSA is often the only way colleges will consider you for financial aid and even students from families earning more than $200,000 a year may qualify for need-based aid from private colleges. The FAFSA may also qualify your child for low-cost, forgivable federal student loans. A January 2015 study by Edvisors found that approximately two million students who would qualify for federal Pell grants don’t even fill out the form. Completing the form may be a pain, but your family may be able to save thousands on college costs. Just do it.