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How to finance a business for your Son or Daughter
First, how not to go about it:
A cash loan is not the way to go.
Neither is signing as surety for a bank loan
A gift of the amount required? Again, not the best approach
But these are the three most common but wrong ways by which
parents try to help their children get started in business.
So what is the best way?
For US residents and citizens, Internal Revenue Code 1244
provides the answer.
If you give your daughter $50,000 say to start a new venture,
and the business goes belly up with the loss of the $50,000,
there is no way that the IRS will allow you to claim this loss
as a deduction.
Or suppose you loan her business $50,000. Again, if things do
not work out, the business will keep paying you the interest
until it runs out of cash, leaving you with a worthless note.
Tax-wise, you have a capital loss, which is deductible at the
pitiful rate of only $3,000 per year against your ordinary
income. Or you can use the loss to offset capital gains.
The same sad tax fate, a capital loss, results if you sign as
surety and must pay Sue's $50,000 loan from the bank.
Tax-wise, a gift to your daughter is even worse. The $50,000 is
hers. As a result, the tax loss is hers, not yours. Under the
circumstances, chances are that Sue has little or no income, and
the loss is almost totally wasted.
Note too that a loan or a bank surety is often questioned by the
IRS. Why? The IRS contends that the $50,000 was a gift because
you never intended to try to collect in the first place. You had
no reasonable expectation of being repaid is the way the IRS
puts it.
But now let's look at IRS Section 1244 - the right way.
Section 1244 allows you to claim an immediate deduction for a
loss on stock in a small business corporation. Your loss is
fully deductible against ordinary income, rather than a limited
capital loss.
And you can claim a maximum Section 1244 loss of $100,000 (joint
return) in a single year or $50,000 on a single return
The maximum amount you can claim as a Section 1244 loss in a
single year is $100,000 on a joint return or $50,000 on a single
return.
So instead of a gift, a loan or a bank surety, you and your
daughter set up a corporation for her new business. You get
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$50,000 of stock in the corporation that qualifies for Section
1244 treatment. Your daughter, who runs the business, draws a
salary
If the business succeeds, your daughter can gradually buy back
your stock (or, better yet, you can gift it to her) over time.
Any profit you make on the buyback will be a low-taxed capital
gain.
If the business fails, your loss will be fully deductible under
Section 1244 (up to the $100,000/$50,000 limits).
Here's another nice thing about Section 1244: The tax benefits are easy
to get. The beneficial tax treatment is automatic and no written
plan is necessary.
A final point: Section 1244 is the way to go not only for your
kids, but also for your spouse who might want to start a new
business. And the same strategy applies if you want to venture
into something new while keeping your present business.
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