This is a somewhat tricky situation.
In general, you could deduct this as a non-business bad debt or, possibly, as worthless investment. In either situation the end result would be a capital loss deductible on Schedule D and subject to capital loss deduction limitations. (If you are not familiar with what that means, let me know and I will elaborate).
If you take the non-business bad debt route, it would be a short term capital loss and should be originally reported in the year that it became uncollectible. The year it became uncollectible might be difficult to establish due to the circumstances. Additionally, you would need to be able to show that you took commercially reasonable attempts to collect the debt. This could include filing suit, getting a judgment, and pursuing asset foreclosure to the extent possible.
If you take the worthless investment route, it should be recorded as a loss in the year that it became worthless. The loss would be either short term or long term depending on what year it actually became worthless. The year that it became worthless might be difficult to establish due to the circumstances. You would also need to establish its worthlessness, preferably by documenting the value of the company as zero or less.
The difficulty that you face has to do with determining the actual timing of the events and correlating that with tax years. In addition, because a family member is involved, the transaction will automatically be more suspect if the IRS ever looks at it. So you need to make sure that your documentation is in order for whatever route you decide to take.[email protected]