When things go wrong, making some money is a lot better than losing money, which isn’t an abstract concept for anyone who invests actively. When you bring money into a relationship, things can get uncomfortable pretty fast, especially when that money is hemorrhaging out of an investment account.
Do you tell the friend to suck it up?
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Do you repay the person out of your pocket? Do you try to make up the difference with new picks? Really, there probably isn’t a good way to deal with losing a friend’s money and you should consider this risk before you agree to invest for anyone. Legal Matters By managing a friend’s money, you may be breaking the law.
The Problems with Investing for Others
Investment professionals must be registered with the Securities and Exchange Commission or have a federal license. If you invest for a friend for compensation, you could be breaking laws that are in place to protect investors from people who aren’t qualified to have discretionary control over others’ accounts. For more insight, see ” Policing the Securities Market: An Overview of the SEC. If that’s the case, you still have to consider whether or not your friend is taking advantage of you.
Helping out a friend is nice, but when that help consists of making significant amounts of money for that person and getting little or nothing in return, you might be suffering from an off-balance relationship. For further reading, check out ” Choosing an Advisor: Wall Street Versus Main Street.
One of the best ways to lend a hand is to help teach your friend about investing. Help Them Learn There are a lot of pitfalls out there for new investors. If you’re lucky, you’ve been able to avoid quite a few of them or you learned how you should have gone about avoiding them. The benefit of your experience can be one heck of an asset to pass on to a friend and it won’t cost either one of you personally or financially.
Can you afford to lose your entire investment? Will any assets be left for you if the business fails? What are the tax consequences of this investment?
Can this investment be structured to provide a tax benefit to you if it fails? Will the investment be a purchase of stock in a small corporation under IRCallowing you to get ordinary loss treatment on the sale of the stock or failure of the business? If the investment is structured as a loan, remember that a loss on a loan to a business is treated by the IRS as a non-business loss. Is the entity an S corporation, LLC, or other pass-through entity? If so, remember that the tax consequences will be passed through to you.
These tax consequences can be profits, losses, capital gains, etc. Make sure you can deal with these tax consequences. You may find that you can’t take advantage of losses because they are passive losses, which can only be used to offset passive income which you may not have. Another potential problem is being taxed on profits that are not distributed.
In a pass-through entity you are taxed on your portion of the taxable income, whether or not any cash has been distributed to you.