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5 Steps To Business Financing With Friends Or Family

Managing Your Bottom Line

If the banks won't budge and you've exhausted your savings, your last resort for financing may be your family

Family financing can be a bonus for everyone involved. If your parents, for example, loan you $40,000 to start a business, and you pay them back, with interest, on a regular repayment schedule, you get start-up capital and a deduction for the interest, while the folks earn some interest income.

However, things get much more complicated when a family loan goes sour. Say your start-up business had a great first year, and you repay $10,000 of the $40,000 loan, with interest. But in year two, you lose two major customers and get behind in meeting obligations, and by year three, you have to declare bankruptcy.

You can start another business next year, but what about your parents? If you cannot repay your loan, they are in a double bind with the IRS. Because most parents or relatives are not considered "in the business" of making loans, they are not eligible for a business bad debt deduction which could allow them to deduct the loss fully in the year the debt is determined uncollectible. Instead, they must try to qualify for a non-business bad debt deduction, which is treated as a short-term capital loss. If your parents have no capital gains (such as gains from the sale of stock) to offset a $30,000 loss, they can only deduct $3,000 of the loss in the year it occurred and carry the balance over to future years.

The IRS may say, however, that the unpaid $30,000 was actually a gift and disallow the deduction. While the tax rules allow each of your parents to "gift" $10,000 a year to any individual, the remaining $10,000 could cause your mom and dad to run afoul of some complicated estate and gift tax rules.

How can you avoid this financial fiasco? Make your loan from family or friends as businesslike as possible, so that they qualify for a non-business bad debt deduction in case your start-up never quite gets off the ground. Here's a five-step checklist to follow when you set up a friendly, but professional, loan with your friends or family members:

1. Insist on a note or other evidence of indebtedness.

2. Pay a market rate of interest.

3. Draw up a fixed repayment schedule.

4. Keep accurate records of repayment.

5. Have proof that your business is solvent at the time of the loan or have a realistic business plan that indicates the loan will be repaid on schedule.

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This article was originally published in the February 1996 print edition of Entrepreneur with the headline: 5 Steps To Business Financing With Friends Or Family.

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