Adding to what has been previously stated, if you take the position that the funds you gave the sole proprietor were indeed a loan and not an equity investment, the burden of establishing that the advances were loans rather than capital contributions rests with the you. In other words, you bear the burden of supporting any position you take on a tax return in the event the loan/investment does not work out as intended. Some of the factors that are relevant in terms of proving that an advance of funds was a loan rather than an equity investment and/or capital contribution are the following:
(1) the names given to the certificates evidencing purported debt;
(2) the presence or absence of a maturity date;
(3) the source of the payments, and in particular whether they are dependent upon earnings;
(4) the right to enforce payment of principal and interest;
(5) whether the advances increase participation in management;
(6) whether the “lender” has a status equal or inferior to that of regular creditors; and
(7) objective indicators of the parties’ intent.
A bad debt deduction and a loss from an equity investment have different tax treatment. Thus, for tax planning purposes, it may be prudent to document earlier rather than later the nature of this transaction, i.e., loan versus equity investment. If equity, then follow the advice of @Robert4444.
@Texasbbs
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