How To Deduct An Ordinary Loss of Up to $100,000 on Qualified Small Business Corporate Stock Under Section 1244 of the Internal Revenue Code

Unfortunately, not all startup companies succeed, however when they fail, all is not lost.  In what may otherwise be considered a complete loss, there are some potential tax benefits available to certain original individual shareholders of corporations in this position.   

After selecting the type of entity to form, if a corporation is the most favorable, I recommend making an S election and issuing Section 1244 stock for this newly incorporated entity.  As long as certain requirements are met, the original investors can claim an ordinary loss of up to $100,000 if the venture is unsuccessful and the stock is ultimately sold for a loss.  

Under normal circumstances, when you invest in corporate stock, any resulting loss on its sale is treated as a capital loss where the loss can offset capital gains and then up to $3,000 of ordinary income per year with the excess capital losses carried forward.  

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Under Section 1244 of the Internal Revenue Code, an ordinary loss deduction for a loss on stock from a “qualified small business corporation” can offset ordinary income and any capital gains. You can deduct up to $100,000 of losses from Section 1244 stock in any one year if  married and file a joint return, or $50,000 if you file as single.  

To qualify under Section 1244, these five requirements must be adhered to:  

1. The stock must be acquired in exchange for cash or property contributed to the corporation. Investors cannot receive shares as compensation for their services. However, cancellation of indebtedness may be sufficiently valid consideration.  

2. The corporation must issue the stock directly to the investors. They cannot acquire the stock from another shareholder, so gifts or inheritance of the shares will not qualify.  

3. The corporation must be an actual, operating company. During the past five years, it must have received less than 50% of its gross receipts from rents, royalties, dividends and other investment income. If the corporation is less than five years old, this test applies to the years it existed.  

4. The stock must be issued by a “small business corporation” defined as a corporation with invested capital of $1,000,000 or less. It can be an S corporation or a C corporation.  

5. The entity must be a domestic corporation.  

Under the current 2020 tax tables, a long-term capital gain that results from the sale of this Section 1244 stock will be taxed at the regular preferential rate of 15% for most individuals or 20% for high-income individuals with taxable income over $441,450. The 3.8% Net Investment Income Tax (NIIT) may also be due.  

Section 1244 of the Internal Revenue Code is the small business stock provision enacted to allow shareholders of domestic small business corporations to deduct a loss on the disposal of such stock as an ordinary loss rather than as a capital loss, which is limited to only $3,000 annually.   A loss on Section 1244 stock is reported on Form 4797 of your personal income tax return, not Schedule D.  

I recommend that when the corporation is set up, corporate records should document that the stock issued qualified as Section 1244 stock. The corporation and the individual shareholders should retain information about the qualifying stock purchased such as the number of shares received, date the stock was issued and price paid for the stock.  

If a partnership purchases Section 1244 stock of another corporate entity and later disposes of the stock at a loss, the partnership entity may pass the ordinary loss through to its partners. Note that for a partner to claim the loss as an ordinary loss instead of a capital loss, the partner must have been a partner when the stock was originally issued and remained so until the time of the loss. 

Alas, if an S corporation owns Section 1244 stock and passes a loss on the stock to its shareholders, they may not deduct the loss as an ordinary loss. Instead, they must deduct the loss as a capital loss.   Shareholders in S corporations who plan to invest in Section 1244 stock issued by other corporations should be certain to 1) acquire the stock directly from the issuing corporation themselves or 2) purchase the stock through a partnership in which they are partners. Assuming all other requirements are met, the stock will qualify as Section 1244 stock, and the taxpayers may deduct as ordinary losses any future losses realized on the stock up to $100,000 per year for joint filers.  

An additional tax planning strategy would be to have the S corporation issue Section 1244 stock to its shareholders. This way, the shareholders will be certain to realize the best of both worlds. They receive the benefit of having items of income and deduction passed through to them from the S corporation. In addition, should they subsequently sell the S corporation stock at a loss, the loss would be deductible as an ordinary loss up to $100,000 per year for joint filers, rather than as a capital loss. 

If you have any questions about Section 1244 stock, call Gregory J. Spadea at 610-521-0604. 

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