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The Bank of Mom and Dad

Your child wants financial help to start a business or go to grad school. Before saying yes...

It's not just the couch-potato kids who are asking their parents for help these days.

In many families, young adult children who have left home and are supporting themselves are also asking mom and dad for help starting a business, paying for graduate school, or launching some other career-oriented project.

"Everyone's thinking more education or going into business for themselves will be a ticket to a better job. Naturally, the Bank of Mom and Dad would be the first place you would stop," says Eleanor Blayney, consumer advocate for Certified Financial Planner Board of Standards Inc., a Washington, D.C.-based regulatory organization for financial planners.

Many parents are inclined to help, especially if their children already have proved to be competent adults. But a well-intentioned gift or loan can easily turn into a family disaster, say experts.

Here's what parents facing such requests need to consider to keep the family on the right track—and the Bank of Mom and Dad on solid footing.

Examine Your Own Plans

First assess how giving the money would affect your own finances and future lifestyle.

Some of the biggest family conflicts arise when a parent stakes a large amount of their net worth on a loan to a child or an investment in a small business and never gets it back, says Jeff Cornwall, director of the Center for Entrepreneurship at Belmont University in Nashville. A good rule of thumb is to not give more than 5% of your net worth to a child for an endeavor, he says.

Estimate the Payoff

Even if your child is supporting him- or herself, they may not be ready to enter a graduate program or run a small business.

"I would look hard at your son or daughter and say, 'Based on my knowledge of this person, can they really pull this off?' You're not doing them a favor by giving them a loan just for their self-esteem," says Mr. Cornwall.

Brendan Synnott co-founded Bear Naked with savings, credit-card debt and financial help from family and friends. ENLARGE

Whether your child's plan is to start a business or boost their income with a graduate degree, they should be clearly outlining the potential payoff and the chances of it happening, says Ms. Blayney of the CFP Board.

Press your child for details before any money changes hands. When David Stier founded Gameday Goods, a New York-based online supplier of sports gifts, he approached his parents with a 25-page business plan that outlined how the venture would turn a profit, among other things.

The now-27-year-old's parents gave him some funding to start his website, along with office space in a commercial property that they manage. But they kept future funding contingent on the business's success. As the business has grown, they've given their son's venture thousands more and remain involved in executive decisions.

"Other families talk about fishing trips during dinner," says Mr. Stier. "We're always talking about business."

When it comes to seed money, it's important for your child to have some skin in the game. When Brendan Synnott started granola-brand Bear Naked in 2002, he and his co-founder each contributed $3,500 of their own savings and together racked up $20,000 in credit-card debt before turning to friends and family for additional funding.

They then raised $750,000 from family and friends, a sum that helped them build a business they eventually sold to Kellogg Co. K -1.48 %

"We were willing to put everything we had on the line. That makes it easier for other people to follow," says Mr. Synnott. "Your investors should not be taking on more risk than you are as a founder."

Setting the Terms

If you say yes to junior, the next decision is: gift or loan? Experts are split.

Susan Ende, a psychotherapist and co-author of "How to Raise Your Adult Children," says she favors gifts, since many loans to children are never paid back anyway. Giving the money as a gift allows them to be more independent, since they're not beholden to paying you back.

But even if no repayment is required, you can attach strings to your gift. Parents could receive a stake in their child's start-up, for example. That way, everybody benefits if the business succeeds, and you won't be adding to your child's debt burden if the company fails.

In 2012, a parent can give a child up to $13,000 tax-free as a gift; in 2013 that limit rises to $14,000. Tuition payments are also exempt from gift tax.

Still, many families opt for a loan. That way, in theory at least, the parents are guaranteed repayment, and the children retain their independence. Draw up loan documents stipulating the terms. If the loan is relatively simple, you can use a standard form available at self-help legal websites, says Mr. Cornwall. If a loan is more complex, you may need a lawyer.

Parents typically set the interest rate for the loan at or above the IRS Applicable Federal Rate for loans. If the IRS audits you and finds out that you're charging less than this official rate on a loan, the agency could adjust your tax return to reflect the interest you should have received.

Create a feasible repayment schedule. In the case of a small business, this typically will be a schedule tied to the business' income, says Mr. Cornwall. In the case of a degree, it could be tied to income after graduation.

You may want to add other conditions, such as a right to call back the loan if a child drops out of school or uses money improperly.

With the high rate of failure among small businesses and the tough job market for graduates, there is a real risk that loans won't be paid back. The family needs to have a frank discussion of what happens if the loan goes bad.

"You tell them, 'If this falls apart, I don't want our relationship to fall apart,' " says Mr. Synnott of Bear Naked. "Families are forever, these businesses only last a period of time."


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