Rewards and risks in lending to your child

Nation's Business, March, 1998 by Gloria Gibbs Marullo

In 1987, when Tom Krueger was 21, he borrowed $30,000 from his father to start Hinges & Handles, an Osceola, Ind., business dealing in home-restoration hardware. Having made the loan, Krueger's father wanted to know Krueger's every, business move.

"It was worse than being in high school," says Krueger. "He wanted to know, exactly where I was going and what I was going to do."

The young entrepreneur started with a good idea -- and good advice. When his first $6,000 inventory of doorknobs didn't sell, he asked the South Bend (Ind.) Small Business Development Center and the Service Corps of Retired Executives (SCORE.) for help with marketing.

SCORE volunteers advised him to get a toll-free telephone number and place a small display ad in a magazine for builders of upscale houses. The doorknobs were gone in a month, and the business has been profitable ever since.

As the business grew and prospered, however, Krueger never repaid the loan. Instead, he and his father incorporated the business in 1993, and the $30,000 became his father's contribution to equity as a 50 percent shareholder. Today, the firm has four full-time employees, and 1997 sales exceeded $700,000.

The Kruegers are a parent-child business-loan success story. But not all such loans result in thriving businesses. Some loans go bad, creating tax headaches for unsuspecting parents. It's important to be aware of the tax consequences before deciding whether to make a business loan to one of your children. Here are some key points to consider:

Be prepared to sue if the loan sours.

Make a business loan to your children "only if you're willing to sue" to collect a bad debt, says Stanley Person, a CPA and senior partner with Person & Co. in New York City.

Under Internal Revenue Service rules, you can't deduct any part of a bad loan from your taxes unless you first try to collect the debt, through legal action if necessary. "You have to treat a business loan to your child like a bank loan and be prepared to act like a bank if the loan goes bad," says Person.

Acting like a bank also means you should have a written loan document. If the business fails and your loan was transacted with only a handshake, you will have trouble convincing the IRS that you made a bona fide loan and that the bad debt is deductible. To qualify for a bad-debt deduction, you must insist on the following documentation:

* A note or other evidence of indebtedness and a written loan agreement.

* A fixed repayment schedule.

* Security or collateral.

* Accurate records of repayment.

* Proof that the business was solvent at the time of the loan.

* A realistic business plan indicating that the loan will be on schedule.

Unlike a bank, few parents can write off the loss as a business bad debt.

If a bank makes a loan to a start-up business and the loan goes bad, the bank first must take legal action to collect the debt. If that doesn't work, the bank can write off the entire loss as a business bad debt in the year the loan becomes worthless.

In rare instances, parents can do the same -- if they can convince the IRS that they are in the business of lending money

At least one taxpayer managed to prove just that in federal Tax Court. In 1987, the taxpayer lent $36,000 to his daughter to start a skating rink. Within a year, however, it became apparent that the rink would never be profitable. The father helped his daughter file for bankruptcy protection and took a business bad-debt deduction. The IRS challenged the deduction, saying the taxpayer was not in the business of making loans.

The taxpayer had evidence, however, that he frequently lent money to individuals and that seven of eight loans made in the previous three years had been repaid. Because the daughter had filed for bankruptcy, the court said the father did not have to sue her to collect the loan because it was clear the daughter had no means to repay the money.

For most parents, however, the most practical tax approach is to claim a nonbusiness bad debt. "But to do this, you first have to sue your child to collect," says Steele Stenger, a CPA with Stenger Bies & Co. in Pittsburgh. "If unsuccessful, the parents can write the loan off as a short-term capital loss."

To take this write-off, the parents would subtract the loan loss from the total of their long- and short-term capital gains for the year. If the loan loss exceeded capital gains, the parents could then deduct $3,000 of the nonbusiness bad debt that year and carry over the rest to deduct in $3,000 increments in subsequent years.

Forget the tax write-off and call the bad loan a gift.

For parents who don't want to add bad blood to bad debts by suing their children, the IRS has a third option: Treat the uncollectable loan as a gift.

The problem with this, says Person, is that you can create a whole new set of tax complications with estate planning if the parents' generosity exceeds the maximum allowable annual tax-free gift.

IRS rules allow a taxpayer to give up to $10,000 each year ($20,000 for two parents)to as many individuals as they want without the taxpayer or the recipients owing tax. (Beginning in 1999, the $10,000 will be indexed for inflation and increased in $1,000 increments.)