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.)
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.
"Twenty years ago I borrowed $10,000 from my dad to get started," says Amos, "and I repaid every dime." Although they never had a formal loan document, they agreed to specific terms and interest.
Amos borrowed from her father several times as her business expanded. "My toughest banking problem," says Amos, "was finally convincing the bank to loan me money without my dad's signature."