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What to consider before lending money to family and friends
When your best friend views your
nest egg as a source of start-up funds for his latest business venture, or your
nephew hits you up for a car loan, your first impulse may be to reach into your
bank account to help. But it's a fact that loans to family and friends often
end up straining both finances and relationships. As Shakespeare said,
"Loan oft loses both itself and friend." In other words, if you lend
money to friends, you often don't get paid back, and the friendship itself may
disintegrate.
It's best to consider a loan to
someone you love as an "arm's length" transaction. If you're
pondering such a loan, keep the following in mind:
* You can just say "no."
It's your money, after all. Do you really want to raid an emergency fund or dip
into your child's college account to finance a friend's business idea? Think
like a bank. It's reasonable to ask tough questions about the person's bank
accounts, potential sources of income, planned use of loan proceeds, and
spending habits before extending credit.
* Consider a gift. If you're
comfortable sharing your resources, you may want to provide a monetary gift
with no strings attached. In many cases, this is the best solution because
neither you nor your friend expect the money to be paid back. Unlike a loan, this
type of arrangement can forestall misunderstandings and hurt feelings later on.
Of course, you should not give money if doing so would unduly strain your own
finances.
* Formalize loans. If you decide to
lend more than a small amount to a friend or family member, it's generally best
to draft a written agreement. This can be as simple as filling out a promissory
note (available online or at office supply stores). Such forms spell out the
basic terms of the loan -- amount, interest rate, payback period -- and provide
some limited protection should you and the borrower end up in small claims
court. Another recent innovation is the use of direct lending (also called
social lending or peer-to-peer lending) websites to facilitate loans between
family and friends. For a fee, such sites can prepare loan documentation, send
payment reminders, issue regular reports, even facilitate electronic fund
transfers. If the loan involves a significant amount of money, check with your
attorney.
Remember: Many personal relationships
have been damaged when loans go awry. So proceed with caution.
Posted in tax
For federal tax purposes, the determination of
"business" or "hobby" is a matter of deduction. If your new
venture is considered a business, you can deduct losses against other income.
However, when the activity is classified as a hobby, the
"hobby loss" rules limit the amount you can write off. Expenses you
incur might be deductible only if you itemize - or they might even be nondeductible.
The distinction affects the amount of tax you owe. So how
can you prove you're trying to run a money-making business despite several
years of losses?
One test you're probably familiar with is the general rule
of earning a profit in three of the past five years. If your business has more
income than deductions in three of five consecutive taxable years, the IRS
generally accepts that you have a profit motive. (The time frame is two years
in seven for certain horse-related activities.)
Unable to meet that test? Additional factors play a role as
well. For instance, the Tax Court agreed that a volleyball consulting service
with multiple loss years qualified as a business, in part because of a
businesslike manner of operation. Among other items, the Court mentioned the
maintenance of a separate bank account and accurate records as support for a
profit motive.
Positive indicators of your profit-making intentions also
include your expertise in the activity, the time and effort you put into your
new business, and your success in other ventures.
If you'd like a complete list of the IRS "business vs.
hobby" criteria, please contact us. We'll be happy to review the
guidelines with you.
Last Updated by Tax on 2013-10-17 03:22:14 PM