Best way to treat this

[taxdude71]

Client invested money in his family members business. Lost the entire amount. There was never any agreement written up for this. Client was not listed as a partner at all, just considered an investor. I'm thinking capital loss with $3k max per year and carryover. Anyone else any thoughts? Any way I can write this off as a loss 100% in the current year?

[ChEAr$]

Client invested money in his family members business. Lost the entire amount. There was never any agreement written up for this. Client was not listed as a partner at all, just considered an investor. I'm thinking capital loss with $3k max per year and carryover. Anyone else any thoughts? Any way I can write this off as a loss 100% in the current year?

Absent a written agreement a bad debt loss would not be deductible. If the business is a corporation, without issuance of stock certificate, there is no capital loss. Same goes for LLC if nothing written as to his being a member, no deduction.

This time, "SOL" doesn't mean "short operating loss." (grin

[taxdude71]

True, but there is a written agreement in place to share in any income from the business. It was just never set up correctly.

[JoshinNC]

Amend prior year corp returns to add him as shareholder

True, but there is a written agreement in place to share in any income from the business. It was just never set up correctly.

And then treat accordingly on personal returns.

[ChEAr$]

True, but there is a written agreement in place to share in any income from the business. It was just never set up correctly.

Still, this is no proof of investment.

Here's what you don't want to hear from a client:

You: Have you proof of that?

Client: No, but don't worry, I can get it in case of audit.

[Gary2]

If there's no proof of investment, what then is it? A gift, implying a 709?

[Roland Slugg]

The OP refers to the T/P as having "invested" in the business but doesn't say what the nature of that investment was ... only that the investor was not a partner. Well, what then? Assuming he was not a shareholder either, about all that's left is "lender." But an investment and a loan are quite different things, and it seems to me that the client/taxpayer should know with certainty which of those categories his funds represented when he parted with them. Of course there's a third possibility: Since this was a family business, the funds may have been a gift to one or more of those family members. If that's the case, then the taxpayer in question has no tax deduction, BUT the person he gave the money to probably would, assuming that he, in turn, put those funds into the business, thus creating basis which he then lost.

If the funds were not an equity "investment" or a gift, but were in fact a loan ... to a business or an individual ... then the bad debt is deductible when it becomes completely worthless. It would be classified as a "non-business" bad debt and thus deductible as a short-term capital loss. See Code §166 and related Regs.

[erchess]

My Sneaking Suspicion

Ok the guy gives money without documentation to a relative who loses it in a business venture. The IRS is going to call this a gift. The only way things could go otherwise would be if the business made money and distributed some to the client in question with appropriate reporting. In that case whatever the business reported it as would likely fly as long as our taxpayer claimed it as the appropriate type of income.

[Gary2]

Since there's a written agreement concerning sharing the income, it's likely that you can show it wasn't a gift. Similarly, from what we've been told about that agreement, it probably isn't a loan, either, since there doesn't seem to be any obligation to pay back principal. In other words, the written agreement, even if flawed, should show an expectation of only being paid if the business was profitable.

That leaves either being a partner, or else the purchase of an intangible, namely a percentage of income. See a recent thread over on that other board (TaxAlmanac), concerning "right to revenues." This case isn't exactly the same as the thread there, since that was a specific percentage of a sales commission, while this seems to be a percentage of business profit. At least I assume the written agreement to "share any income" was referring to either gross or net profit, and not a percentage of revenue.

[taxdude71]

Thank you for the opinions. I'm pretty sure he's able to claim it as a capital loss. If it wasn't clear before, the business was run as a partnership but never set up that way.

[ChEAr$]

One just has to wonder how the business enterprise treated the funds on it's books. eh?

[Gary2]

Thank you for the opinions. I'm pretty sure he's able to claim it as a capital loss. If it wasn't clear before, the business was run as a partnership but never set up that way.

What do you mean "never set up that way"? Partnerships can come into existence on verbal agreements; there's nothing that has to be set up.

[Corduroy Frog]

Related party

I'm surprised in the foregoing discussion there has been nothing said about "Related Taxpayers" since the OP mentioned the loan was to family members.

I tell my clients they can't just deduct loans to family members that never get paid. If there was no record of a structured capital investment, I wouldn't allow the loss.

We have often discussed the two bozo-faced guys who show up in your office and say "Well, we're sorta partners" and how it almost NEVER works to attempt to file a partnership return in such a case. Especially when you tell these idiots that they will have to establish a bookkeeping system and pay big money in tax preparation. This kind of dialogue turns the "sorta partners" into "Well, not really partners, he does his thing and I do my thing."