Sara Gould advises:

Family "angels" CAN claim capital losses

Hopeful entrepreneurs usually turn to "family and friends" for initial capital.  What parents could turn down their children, either financially or emotionally, when the kids want to become business owners?

But what if the business crashes?  When a parent provides the money for the child's venture, any loss will be treated as a bad-debt loss, which greatly limits the tax value.

There IS a way for parent-investors to secure extra tax protection:  Make the investment with Section 1244 stock.  With this tool, parents and other investors can deduct as much as $100,000 in losses if the child's business goes under.

How does Section 1244 stock work?

When a parent makes a simple investment in a child's new business, any loss is treated as nonbusiness bad debt.  This means that the loss is first used to offset any capital gains, then only up to $3,000 can be deducted against ordinary income from salary, interest, etc.

However, under Section 1244 of the tax code, the parent can claim a tax deduction for a loss on stock from a "qualified small business corporation."  (IRC Sec. 12244[c][3])  The loss can be fully deducted against ordinary income, as well as any capital gains.  For a single filer, the deduction can be up to $50,000 of losses from Section 1244 stock in any one year.  For joint filers, the deduction can be up to $100,000.  (IRC Sec. 1244[b])

To qualify for Section 1244 treatment:

a.  The corporation must issue the stock directly to the investors.  An investor cannot  acquire the stock from another shareholder and deduct any loss against ordinary income.

b.  The stock must be acquired in exchange for cash or property contributed to the corporation.  This means that investors cannot be paid for services with such shares of stock.

c.  The stock must be issued by a "small business corporation."  In this case, a small business corporation is defined as a corporation with invested capital of $1 million or less, whether an S corporation or a C corporation.

d.  The corporation is an actual operating company.  During the past five years, the corporation must have taken in less that 50% of its gross receipts from rents, royalties, dividends or other investment income.  If the corporation is less than five years old, this test is applied to only the years it has been in existence.  (IRS regulation 1.1244[c]-1[e])

NOTE:  Section 1244 applies only to losses, not gains.  If the business makes money, the child can buy out the parents' investment.  Such profits to the parents are treated as capital gains taxed at the 15% maximum rate.

EXAMPLE:  Let's look at how much such a tax strategy can affect the investing parent.  Suppose Jack gives his daughter Lisa $75,000 to start her new business.  In this particular year, Jack has $25,000 in capital gains and he is in the 35% tax bracket.

Bad planning:  If Jack just fronts the money to Lisa and doesn't take care of all the technicalities of a loan, the IRS may say that his $75,000 is a gift.  In this case, Jack wouldn't be able to write off a dime of the loss should Lisa's company fail this year.

Of course, the IRS could actually challenge the loan (since it is well above the $24,000 that Jack and his wife could "gift" to Lisa).  Even if the IRS doesn't challenge the loan, the bad-debt loss can only be deducted as a capital loss.  Jack offsets the $25,000 capital gain then applies $3,000 toward ordinary income.  He would have to carry over the excess loss.

Result:  Jack saves only $4,800 in taxes off his 2007 tax bill (15% of $25,000, plus 35% of $3,000).

Good planning:  Now, let's say Jack asks Lisa's company to issue him Section 1244 stock.

If Lisa's company goes under, Jack could deduct his entire $75,000 loss as an ordinary loss in the year the company fails.  The result is the loss saves Jack $26,250 in tax (35% of $75,000).

The difference is a staggering $21,450!