Rewards and risks in lending to your child

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

For example, if the bad loan is no more than $40,000 and the child is married, the parents could qualify for the annual gift exclusion (two parents giving $20,000 to their child and another $20,000 to the spouse) in the year the loan becomes worthless. But gifting more than $10,000 per person per year during a parent's lifetime could later increase the taxes due on the parent's estate.

(Gift and estate taxes are combined through the "unified credit." For example, if a taxpayer exceeds the $10,000 per person annual gift exclusion by $20,000 a year for five years, or $100,000, the donor's $600,000 exemption for estate-tax purposes is reduced to $500,000. The unified credit is gradually being increased to exempt $1 million by 2006.)

The IRS may hold parents personally responsible for a child's bad debts.

Yet another tax trap for unsuspecting parents can emerge if a parent supplies the cash to form a corporation and the child runs the business.

In one instance, Stenger had a client who contributed cash to start a son's business. In return, the son made the father an officer in the corporation, with check-writing authority. The father's involvement in the day-to-day operation of the business was minimal. Nonetheless, when the son didn't remit $10,000 in company payroll taxes, the IRS forced the father to pay the taxes from his personal bank account.

Divorce and poorly documented business loans can create significant problems.

You want to be extra careful about lending money to children who, though they might have good business skills, have bad marriages. "This isn't as much a tax issue as a red flag for the need for legal agreements and loan documentation," says Person. "I've had parents loan money to a married son who then gets a divorce. Without proper documentation of the amount of the loan and who is responsible for repaying it on what terms, the ex-wife can either claim the money was a gift or walk away from any responsibility to repay the loan."

In a worst-case scenario, when the couple divides the marital assets, the former spouse could end up with a major or controlling interest in a successful business that has been bankrolled by her former in-laws.

In addition to formal documentation, Person recommends that parents use common sense before lending money to start their children in business.

"Don't make a loan to your kid," says Person, "if you know there's a problem with alcohol or drugs. Don't give money to a child to open a garage if he doesn't know how to change oil."

Hardware entrepreneur Krueger was still in college when he started Hinges & Handles, but he had worked in his father's hardware store since junior high school.

Despite the potential tax and estate-planning pitfalls, most parent-to-child business loans don't go bad, says Person.

Joann Amos, president of Reflections Photography in Washington, D.C., got her start photographing fraternity and sorority parties while attending the University of Kentucky. Amos specializes in event photography and was the official photographer for the 1996 Republican National Convention in San Diego.