Raising capital is often the biggest barrier to launching a new business, so it’s not uncommon for budding entrepreneurs to turn to their families and friends for help.
If you’re approached with such a request, your first instinct may be to lend a hand, no questions asked—especially if your child is doing the asking. But such assistance should be viewed as a financial transaction like any other.
Even a small home business can cost a few thousand dollars to get off the ground. Before you provide seed money, you’ll want to answer all questions up front, meeting with an attorney or tax specialist to discuss any financial obligations or implications involved. You should make sure the recipient understands, as well.
To keep the personal from bleeding into the professional, try to firmly separate the two from the start. Make clear that your questions and feedback are meant to foster productive discussions rather than to criticize or micromanage your family member.
Once you’ve set the terms of engagement, have your loved one walk you through the business plan, including short- and long-term goals and the outlook for turning a profit. If—after reviewing the details and satisfying all your questions—you do decide to help, there are three basic options for funding a family member’s business: a gift, a loan, or a direct investment. Here’s what to consider with each.
From a legal and tax perspective, a gift is the simplest option. It involves no expectation of repayment or return on the giver’s investment. You can gift up to $15,000 a year without facing tax consequences. If you exceed that amount, you’ll need to file a Form 709 with the IRS; however, even then, the gift merely counts against your lifetime gift-tax exemption, which as of 2021 is $11.7 million per individual.
Whether or not you file a Form 709, it’s still important to document all gifts, even if it’s just with a simple letter that’s kept with your other financial records. When it comes time to settle your estate, this document can clear up questions about whether the money was indeed a gift, as opposed to a loan. You might also consider either matching gifts for the recipient’s siblings or updating your estate plan to reflect any gifts or advances.
Keep in mind, however, that a gift doesn’t automatically make you a business partner or entitle you to say how the money is spent. If you want to be involved in business decisions, gifting the money may not be the best option for you.
Like a gift, a loan won’t grow in value should your family member’s business take off. But unlike a gift, a loan involves an obligation—ideally one documented as a promissory note with the relevant terms established:
- Will the loan be secured (i.e., backed by collateral) or unsecured?
- Will the borrower pay interest? If so, how much and on what schedule?
- Will the borrower make principal payments? If so, how much and on what schedule?
- Will the loan need to be repaid in full by a certain date? If so, when, and will there be a grace period?
Documenting the loan can also avoid issues with the IRS, which imposes penalties on zero- or minimal-interest loans. The IRS sets a minimum rate for loans, called the applicable federal rate (AFR), which changes each month but generally approximates the rate paid by certificates of deposit and savings accounts. If your loan rate is below the AFR, or the IRS determines that the loan wasn’t really a loan at all, the government may treat it as a gift for tax purposes—even if there’s a promissory note.
As for the loan’s repayment structure, you can choose a term loan, which has specified repayment dates, or a demand loan, which you can call due at any time. The AFR may vary depending on which kind of loan you opt for, so you’d be wise to work out the details with an accountant. You must report any interest from such loans as taxable income.
If the borrower defaults on the loan, you may be eligible for a tax deduction—which could be cold comfort if the default causes you financial strain or sours your relationship with the borrower. As the lender, you legally have every right to collect the money, but you might decide your relationship is more important than recouping the funds.
One way around such fraught situations is to treat a default as an advance on the heir’s inheritance. Including these stipulations in the loan document can help prevent conflict down the road.
Unlike gifts and loans, this funding method gives you an equity stake in the company. If your loved one founds the next Amazon, for example, you’ll share in its success, but you also can lose your investment should the enterprise fail. In any case, this route involves its own share of questions, including:
- What are you getting in return for your investment?
- Will you receive dividends, an increase in the value of your investment, or both?
- What happens to your stake if the company raises capital from new investors in the future?
If you want to be involved in running the business, a direct investment is probably the best way to go about it. Before exchanging any funds, both parties should be clear of your role. Your loved one may be looking for a silent investor, not a partner, and unwanted input on how best to run the business could lead to family strife.
Direct investments are also subject to federal and state securities laws. An attorney can help you navigate them, as well as determine the appropriate investment structure, be it a corporation, a limited liability company, or a limited partnership.
Think big picture
However you may choose to fund a loved one’s business, bear in mind that investment opportunities come and go, but family is forever. The key is to separate the investment from emotions. If that’s not possible, there are other sources for business funding.
What You Can Do Next
Read more about the difference between gifts and family loans.