Insights

Claiming An Ordinary Loss Of Up To $100,000
For A Loss On Stock On Select Small Businesses

Normally, if a taxpayer invests in a new business, any resulting loss is treated as a capital loss. The loss must first be used to offset capital gains and then up to $3,000 of ordinary income from salary, interest, etc. Any excess loss is then carried over to the next year.

Under Section 1244 of the tax code, you can claim an ordinary loss tax deduction for a loss on stock from a “qualified small business corporation.” The loss is fully deductible against ordinary income as well as any capital gains. Single filers can deduct up to $50,000 of losses from Section 1244 stock in any one year, while joint filers may write off as much as $100,000.

Eligibility for Section 1244
Be aware, however, that this special tax treatment isn’t automatic. To qualify for Section 1244 treatment, the following four main requirements must be met:

• The corporation must issue the stock directly to the investors. They can’t acquire the stock from another shareholder and deduct a loss against ordinary income.
• The stock must be acquired in exchange for cash or property contributed to the corporation. Investors can’t receive the shares as compensation for their services.
• A “small business corporation” must issue the stock. For this purpose, a small business corporation is defined as a corporation with invested capital of $1 million or less. It can be an S corporation or a regular C corporation.
• The corporation is an actual, operating company. During the past five years, the corporation 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’s been in existence.

Election Requirements
There is no election required before issuing “Section 1244 stock” or after Section 1244 stock is issued.  A corporation’s organizational documents do not need to refer to Section 1244.  The board of directors is not required to approve the issuance of Section 1244 stock.  No filing with the IRS is required when Section 1244 stock is issued; nor is any filing required with the tax return for the year of issuance. Stockholders and management should maintain the records necessary to establish that stock qualifies as Section 1244 stock.  These records include documentation necessary to establish that the corporation met the gross receipts test discussed above at the time of the issuance of the Section 1244 stock.

S Corporations and Section 1244
S corporations can issue Section 1244 stock.   But typically, when an S corporation fails, previously allocated losses will have reduced a stockholder’s tax basis in the Section 1244 stock (i.e., the S corporation stock) to the point where the additional ordinary loss to be claimed is at, or near, zero.

Partnerships and Section 1244
For partnerships to qualify under Section 1244, a conversion is necessary.  Two partnership conversion methods that work for Section 1244 purposes (1) involve the contribution of partnership interests to the corporation in exchange for stock, and (2) the contribution of assets by a partnership, but only if the partnership retains ownership of the Section 1244 stock.  Such conversions should be carefully documented to take advantage of the Section 1244 provision for ordinary loss treatment.

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The information presented here should not be construed as legal, tax, accounting, or valuation advice. No one should act on such information without appropriate professional advice and after a thorough examination of the particular situation.