This post originally appeared on Forbes.
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.