What's the best way to help your son (or daughter) start a new business?
Suppose your daughter Pam needs $50,000 to start her new venture. You've reviewed the concept and think she can make a go of it. But what if you're wrong and Pam ultimately loses the $50,000? Can you deduct your $50,000 loss without the IRS shooting you down?
First the three painful wrong roads: (1) You loan Pam the $50,000; take back her note; her business pays you interest until it goes broke. Tax wise, you have a capital loss, which is deductible at the pitiful rate of $3,000 per year against your ordinary income (or you can use the loss to offset capital gains). (2) The same sad tax fate—a capital loss—results if you sign as surety and must pay Pam's $50,000 loan to the bank. (3) A gift to Pam is even worse tax wise. The $50,000 is now hers. As a result the tax loss is hers. Chances are Pam has little or no income and the loss is almost totally wasted.
A loan or surety is often attacked by the IRS. Why? The IRS contends the $50,000 was a gift because you never intended to try to collect from Pam in the first place.
Section 1244 is the right road. It allows you to claim an immediate deduction against ordinary income rather than a limited capital loss. The maximum amount you can claim as a Section 1244 loss in any one year is $100,000 on a joint return or $50,000 on a single return.
How to do it right? You and Pam set up a corporation for Pam's new business. In exchange for $50,000, you get stock in the corporation that qualifies for Section 1244 treatment. Pam runs the business and receives a salary. If the business succeeds, Pam can gradually buy back your stock (or you can gift it to her) over time. Any profit you make on the buy back will be a low-taxed capital gain. If the business fails, your loss will be fully deductible under Section 1244.
Here's one more nice thing about Section 1244: The tax benefits are easy to get and are automatic. No written plan is necessary.
One final point: Section 1244 is the way to go if your spouse wants to start a new business. The same strategy applies if you want to venture into something new while keeping your present business.
When To Start Your Wealth Transfer Planning?
When should you start estate (or wealth transfer) planning? The sooner you start, the better for you and your family. The simple truth is that there are ways to pass every dime of your wealth intact to your family. Best of all, it works no matter how old you are or how much you are worth.
One of the basic principles of winning the wealth-transfer-planning game is to get into a tax-free environment. Then, stay in that environment for as long as you can. Here's what you accomplish: Your wealth grows at an accelerated rate because it is compounding tax-free.
For example, a sum of money (say $100,000) will double every eight years if it earns 9 percent a year tax-free. So in 24 years (about one generation), the $100,000 will grow to $800,000. In a second 24-year generation, that original $100,000 will reach $6.4 million.
Let's summarize. If you are young, get into a tax-free environment as soon as you can. If you are not young, put your kids or grandchildren into the tax-free environment. Start now with an appropriate gift-giving program. You can disinherit the IRS and transfer your wealth intact to your family.