Even with the economic uncertainty brought on by the pandemic, applications for new businesses hit an all-time high in 2020. Family members often are a key source of funding for new entrepreneurs trying to get their big idea off the ground. But when deciding whether to invest in your nephew’s “sure thing,” it’s important to follow your head and not just your heart.
Be realistic about your own finances, first
Is this money you truly can afford to part with? Even if you have money to contribute, examine how lending or investing it in a business would affect your overall financial plan. For example, if you withdraw money from a retirement plan, will that mean you will need to work additional years to make up the gap? A financial advisor, attorney or accountant can help you run the numbers.
Scrutinize the viability of the business
If you can part with the money, do your due diligence before investing. Sometimes that can be easy if, for example, you’re a successful restaurateur and your son needs money to launch his first food truck. If you’re not an expert, meet with an attorney or accountant to discuss whether the business plan is viable and represents a good investment.
“You’re likely contributing a substantial amount of money,” said Tamara Telesko, Director, Wealth Planning Strategies with TIAA. “That’s why it’s critical to get an outside, objective viewpoint. Consider the opportunity from a financial point of view, not an emotional one.”
Gift, investment or loan?
If you do decide to contribute, determine whether your money will be a loan, investment or outright gift. The distinction is important for tax and estate-planning purposes.
Loan: If you’re lending a loved one money for their business, be sure to document the details of the loan. Put into writing the amount, whether the money will be provided all at once or in installments, and a repayment schedule.
Loans between family members are required to charge the Applicable Federal Rate (AFR), which is set by the IRS and ensures a loan isn’t simply a gift. Though the interest payments you will receive are counted as taxable income, AFR rates are currently very low, making this an attractive option for both borrower and lender, adds Telesko. If your family member defaults on the loan, you may be able to claim the loan as a short-term capital loss.
Investment: Becoming an investor in a business also requires documenting certain agreements upfront, even if you’re planning to operate as a silent partner. Questions you’ll need to answer include: Does your investment give you ownership of a certain percentage of the business? If more investors come on board, will your portion be diluted? If the business takes off, will your stake grow in value commensurately?
Gift: As an individual, you can gift up to $15,000 to any other individual without triggering taxes. Married couples can give up to $30,000. Anything above that dollar amount will be considered a taxable gift and reduce both the lifetime- and estate-tax exemptions, which both are $11.7 million currently. In addition, you’ll need to file a gift tax return to account for this gift.
Make sure you’re protected
Most people are not prepared to risk more than they’ve invested. If you’re investing as an equity partner, make sure the business is structured as a limited liability company, a limited partnership or a corporation. These types of ownership arrangements will provide you, as an equity partner, protection from losing more than your initial investment.
If the business operates as a sole proprietorship, an equity partner could be subject to personal liability for the debts of the business—even if those debts are more than the equity partner’s initial investment.