3 Ways to Invest in a Family Member’s Business

Raising capital is often the biggest barrier to launching a new business, so it’s not uncommon for budding entrepreneurs to turn to their families and friends for help.

If you’re approached with such a request, your first instinct may be to lend a hand, no questions asked—especially if it’s your child who’s doing the asking. But such assistance should be viewed as a financial transaction like any other, and you should make sure the recipient understands that, as well.

“Don’t just think, This is my child and therefore it’ll work out fine,” says Marianne Hayes, a CPA and wealth strategist with Schwab Private Client. “You need answers to all your financial questions up front, even if that means consulting an attorney or a tax specialist.”

To keep the personal from bleeding into the professional, try to firmly separate the two from the start. “Make it clear that all questions and feedback are coming from you as a business associate rather than as a family member,” Marianne says. “That should pave the way for more productive discussions and help ease any tensions.”

Once you’ve set the terms of engagement, have your loved one walk you through the business plan, including short- and long-term goals and the outlook for turning a profit. “You want to see passion and preparation in equal measure,” Marianne says. “They need to show they’ve thought this through and anticipated potential roadblocks.”

If, after reviewing the details and satisfying all your questions, you do decide to help, there are three basic options for funding a family member’s business: a gift, a loan, or a direct investment. Here’s what to consider with each.

1. Gifts

From a legal and tax perspective, a gift is the simplest option. It involves no expectation of repayment or return on the giver’s investment. You can gift up to $15,000 a year without facing tax consequences. If you exceed that amount, you’ll need to file a Form 709 with the IRS; however, even then the gift merely counts against your lifetime gift-tax exemption, which as of 2020 is $11.58 million per individual.

Whether or not you file a Form 709, it’s still important to document all gifts, even if it’s just with a simple letter that’s kept with your other financial records. When it comes time to settle your estate, this document can clear up questions about whether the money was indeed a gift (as opposed to a loan). You might also consider either matching gifts for the recipient’s siblings or updating your estate plan to reflect any gifts or advances.

Be aware, however, that a gift doesn’t entitle you to say how the money is spent. “Many gift-givers feel it’s their right to be involved in business decisions, but that’s not the case,” Marianne says. “If you want a role in the company, a gift may not be the best funding option for you.”

Seed money
Small businesses use a variety of sources to fund and grow their companies.

Source: MetLife & U.S. Chamber of Commerce Small Business Index, Q1 2020.

 

2. Loans

Like a gift, a loan won’t grow in value should your family member’s business take off. But unlike a gift, a loan involves an obligation—ideally one documented as a promissory note with the relevant terms established:

  • Will the loan be secured (i.e., backed by collateral) or unsecured?
  • Will the borrower pay interest? If so, how much and on what schedule?
  • Will the borrower make principal payments? If so, how much and on what schedule?
  • Will the loan need to be repaid in full by a certain date? If so, when—and what, if any, grace period will there be?
     

Documenting the loan can also avoid issues with the IRS, which imposes penalties on zero- or minimal-interest loans. The IRS sets a minimum rate for loans, called the applicable federal rate (AFR), which changes each month but generally approximates the rate paid by certificates of deposit and savings accounts. If your loan’s rate is below the AFR or the IRS determines that the loan wasn’t really a loan at all, it may treat it as a gift for tax purposes, even if there’s a promissory note. (View the current AFR.)

As for the loan’s repayment structure, you can choose a term loan, which has specified repayment dates, or a demand loan, which you can call due at any time. The AFR may vary depending on which kind of loan you opt for, so it’s wise to work out the details with an accountant.

You must also report any interest from such loans as taxable income. By the same token, if the borrower defaults on the loan, you may be eligible for a tax deduction. “Defaults are particularly tricky,” Marianne says. “You have every right to try to collect, but you might decide that preserving the relationship is more important than recouping the funds.”

One way around such fraught situations is to treat a default as an advance on the heir’s inheritance. “That way, you don’t have to deal with the headache or heartache of trying to collect, but your heir is still held accountable for the loss,” Marianne says. Make sure these details are stipulated in the loan document to help avoid conflict down the road.

3. Investments

Unlike gifts and loans, this funding method gives you an equity stake in the company. If your loved one founds the next Amazon, for example, you’ll share in its success, but you also can lose your investment should the enterprise fail. In any case, this route involves its own share of questions, including:

  • What are you getting in return for your investment?
  • Will you receive dividends, an increase in the value of your investment, or both?
  • What happens to your stake if the company raises capital from new investors in the future?
     

If you want to be involved in the running of the business, a direct investment is probably the best way to go about it. “Make sure you nail down your role in the company before you hand over any funds,” Marianne says. “Your loved one may be looking for a silent investor, not a partner, and unwanted input on how best to run the business could lead to family strife.”

Direct investments are also subject to federal and state securities laws. An attorney can help you navigate them, as well as determine the appropriate investment structure, be it a corporation, a limited liability company, or a limited partnership.

Think big picture

However you may choose to fund a loved one’s business, bear in mind that investment opportunities come and go, but family is forever. “The key,” Marianne says, “is to separate the investment from the emotion. And if everyone involved can’t do that, you may want to go another way.”

Next Steps

  • Need help thinking through how funding a family business fits into your financial plan? With Schwab Intelligent Portfolios Premium™, you can get one-on-one help from a Certified Financial Planner™ professional. Learn more today.

Important Disclosures

Please read the Schwab Intelligent Portfolios Solutions™ disclosure brochures for important information, pricing, and disclosures related to the Schwab Intelligent Portfolios and Schwab Intelligent Portfolios Premium programs. Schwab Intelligent Portfolios® and Schwab Intelligent Portfolios Premium™ are made available through Charles Schwab & Co., Inc., (“Schwab”), a dually registered investment advisor and broker dealer. Portfolio management services are provided by Charles Schwab Investment Advisory, Inc. (“CSIA”). Schwab and CSIA are subsidiaries of The Charles Schwab Corporation.

This information does not constitute and is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner, or investment manager.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

All corporate names are for illustrative purposes only and are not a recommendation.