Business loan from parents or gift??

[KJ Judd]

Client started business with $100k loan from parents. Much discussion the past two years, but he produced a written promissory note and indicated intent to repay. Business had been making payments on loan. So I treated as business loan.

In 2006, client went out of business. Now client says parents deducted interest expense (they took out a home equity loan for the $100k) for 2006, what would happen if he doesn't claim interest expense on his Schedule C.

Also, the business did very poorly, he has suspended losses from the business and the loan amount put him "at-risk". He's taken responsibility for filing 1099s in prior years, and did not send a 1099-INT to his parents.

Sorry this is such a long post, but what options do we have? I see potential disallowing the loan in prior years, potential forgiveness of debt or potential gift tax issues. Any input would be most appreciated!

[solomon]

As you describe it

the note made the loan valid as well as the business making payments. Now that your client is out of business, I would think it depends how the parents handle it. That is to say, are they going to try to collect it and if so and it is impossible to collect it because of client's financial condition, then I would construe it as a bad debt for the parents.

On the other hand, if they forgive the debt would it not be income to your client? I don't see it as a gift at the beginning. Perhaps they could gift split and apply 24 each year on the balance - don't know if that is legitimate however.

Regarding client not claiming interest on Sch C, I don't see that as a problem if he is out of business.