Ways to invest in a family member’s business

Raising capital is often the biggest hurdle to starting 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 asking. But such aid 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 of the following questions by meeting with an attorney or tax expert to discuss any financial obligations or implications involved. You should make sure that the recipient also understands.

To avoid the personal bleeding into the professional, try to firmly separate the two from the start. Make it clear that your questions and feedback are meant to foster productive discussions rather than criticize or micromanage your family member.

Once you’ve set the terms of engagement, let your loved one walk you through the business plan, including short- and long-term goals and an outlook for profit. If—after reviewing the details and answering all of your questions—you 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.

1. Gift

From a legal and tax perspective, a gift is the simplest option. There is no expectation of payment or return on the giver’s investment. You can gift up to $15,000 per year without facing tax consequences. If you exceed that amount, you’ll need to file Form 709 with the IRS; However, even then, the gift only counts against your lifetime gift-tax exemption, which is $11.7 million per person through 2021.

Whether you file Form 709 or not, it’s still important to document all gifts, even if it’s just a simple letter that’s kept with your other financial records. When it comes time to settle your estate, this document can clarify questions about whether the money was truly a gift as opposed to a loan. You may also consider updating your estate plan to reflect matching gifts or any gifts or advances to the recipient’s siblings.

However, keep in mind that a gift does not 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 money may not be the best option for you.

2. Loans

Like a gift, the value of the loan will not increase when your family member’s business closes. But unlike a gift, a loan involves an obligation – ideally documented as a promissory note with associated terms:

  • Will the loan be secured (ie, backed by collateral) or unsecured?
  • Will the borrower pay interest? If so, how much and on what schedule?
  • Will the borrower pay the principal? If so, how much and on what schedule?
  • Will full repayment of the loan be required by a certain date? If so, when, and will there be a grace period?

Documenting the loan can also avoid problems 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 varies from month to month but generally approximates the rate paid by certificates of deposit and savings accounts. If your loan rate is less than the AFR, or the IRS determines that the loan was not really a loan, the government may treat it as a gift for tax purposes—even if there is a promissory note. 

As for the repayment structure of the loan, you can opt for a term loan, which has specified repayment dates, or a demand loan, which you can call at any time. AFR can vary depending on the type of loan you opt for, so you’d be wise to check the details with an accountant. You should report any interest from the loan as taxable income. 

If the borrower defaults on the loan, you may be eligible for a tax deduction—which can be very comforting if the default puts you under financial strain or sours your relationship with the borrower. As a lender, you have every right to legally collect money, but you may decide that your relationship is more important than recovering the funds.

One way out of such fraught situations is to treat the default as an advance on the heir’s inheritance. Including these conditions in the loan document can help prevent conflicts down the road.

3. Investments

Unlike gifts and loans, this funding method gives you an equity stake in the company. If your loved one finds the next Amazon, for example, you’ll share in its success, but you could also lose your investment if the enterprise fails. In any case, this path involves its own set of questions, including:

  • What do you get in return for your investment?
  • Will you receive dividends, an increase in the value of your investment, or both?
  • What will happen to your share if the company raises capital from new investors in the future?

If you want to be involved in running a business, direct investment is the best way to go about it. Before exchanging any funds, both parties should be clear about your role. Your loved one may be looking for a silent investor, not a colleague, and unwanted input on how best to run the business could lead to family feuds.

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, limited liability company, or limited partnership.

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