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 $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.