Section 1244 Stock: How to Claim Ordinary Loss in Small Business

KEY TAKEAWAYS

• Section 1244 stock allows investors to claim an ordinary loss on the sale of certain small business stocks.
• To qualify, the stock must be originally issued for cash or other property, not services.
• You must hold the stock continually for more than one year after the stock was issued. The issuing corporation must meet certain criteria of gross receipts and number of shareholders.
• If you sell your Section 1244 stock at a loss, you can claim up to $50,000 per year as an ordinary loss on your taxes.

What Is Section 1244 Stock?

Section 1244 stock is a type of equity investment in a small business. It allows investors to claim an ordinary loss on the investment rather than a capital loss if the investment goes bad. The maximum loss that can get claimed is $50,000 per year, or $100,000 for married couples filing jointly. 

To qualify as Section 1244 stock, the shares must come from a domestic C, or S corporation, and it must represent original ownership in the corporation (i.e., not purchased from another shareholder). At least 60% of the corporation’s assets must consist of cash, receivables, and/or inventory. Also, the corporation’s total capital cannot have exceeded $1 million when the shares were issued, and the business cannot generate more than 50% of its income from passive investments (e.g. rentals).

If you meet these requirements, investors can claim an ordinary loss on the investment if it becomes worthless or sold for a loss. This is a significant benefit, as ordinary losses can offset other types of income such as salary or interest income on your tax return. Additionally, ordinary losses are not offset by capital gains.

It’s important to note that Section 1244 stock differs from other types of equity investments, such as common or preferred stock. With those investments, investors can only claim a capital loss if the investment goes bad.

Qualifying for Section 1244 Stock

To qualify for Section 1244 stock, the company must be a small business corporation as defined in Section 1244 of the Internal Revenue Code. This means that:

• The corporation’s primary business must be something other than investing, e.g. manufacturing, farming, or retail trade.
• The corporation can’t have more than $5 million in total assets at the time the stock gets issued.
• Stock must’ve been originally issued for money, property, or services rendered to the corporation, not for another security, such as stock in another company.
• The corporation must not be public on an established securities market before the issuance of the Section 1244 stock.

If the company meets these criteria, investors who buy Section 1244 stock can claim a loss of up to $50,000 per year, or $100,000 if filing jointly. This is on their personal income tax returns. This loss can offset other forms of income, such as salary or investment gains.

What are the Advantages of Section 1244 Stock?

1. Section 1244 stock allows small business owners to take an ordinary loss on the sale or disposition of their company’s stock. This is a significant advantage for small business owners facing significant financial challenges.
   
2. When a small business owner sells their company’s stock, they can claim a capital loss. Capital losses can only offset capital gains, and any excess losses can only offset up to $3,000 of other income. 

However, with Section 1244 stock, small business owners can take an ordinary loss on the sale of their company’s stock. This means that they can use the losses to offset any ordinary income, including wages and salaries.

3. Another advantage of Section 1244 stock is that it allows small business owners to take a loss on the sale of their company’s stock. They can then reinvest the proceeds into another small business. This can be a significant advantage for small business owners who are looking to expand their businesses.

Section 1244 stock is an attractive option for small business owners for a number of reasons, but it’s important to understand the rules and regulations surrounding this type of stock before claiming any losses. If you don’t, you may owe the extent of capital gains from the sale of your company’s stock.

Tax Benefit of Section 1244 Stock

To encourage investments in small businesses, the IRC provides a tax benefit for losses incurred on “Section 1244” stock. Under section 1244 of the IRC, an individual can elect to treat up to $50,000 of losses arising from the sale or exchange of certain small businesses. The losses have to be ordinary losses rather than capital losses. 

This treatment is available regardless of whether you hold the stock as a short-term or long-term investment. To qualify for this preferential tax treatment, an individual must be the original owner of the stock, and it must have been issued for money or property (other than stock or securities).

The issuing corporation must be a domestic C, or S corporation. It must have total gross assets of less than $50 million immediately after issuing the stock. Moreover, you must not acquire the exchanges of stock with a view to selling it at a profit within two years of its issuance.

What if you meet the requirements for this favorable treatment? Then up to $50,000 of losses, or $100,000 if filing jointly with a spouse, incurred on the sale or exchange of the stock can be deducted as an ordinary loss on your federal income tax return. This deduction is available regardless of whether you itemize your deductions.

Losses in excess of $50,000 are capital losses and can only offset capital gains, plus up to $3,000 of other ordinary income. Capital losses in excess of capital gains plus $3,000 can carry forward to offset capital gains in future years.

If you have significant losses on Section 1244 stock, it makes sense to consider selling other capital assets with capital gains to maximize the tax benefit. For example, suppose you have $60,000 of losses on Section 1244 stock and $40,000 of long-term capital gains from the sale of mutual fund shares. By selling the Section 1244 stock, you can deduct the entire $60,000 loss as an ordinary loss on your current year’s return. This will shelter the $40,000 of capital gains, plus up to $3,000 of other ordinary income from taxation. Of course, you should always consult with a tax advisor before making any decisions about the sale of investments.

How Does Section 1244 Stock Affect You?

Section 1244 stock can affect you if you’re an individual shareholder in a small business corporation (C or S corporation), or a limited liability company (LLC). The stock issuance must come from the corporation or LLC for money or other property, and it must represent the original issuance of the shares.

If you meet the requirements, any loss you incur on the sale or exchange of Section 1244 stock is an ordinary loss. This means that you can deduct the loss on your personal tax return, up to $50,000 per year, or $100,000 if filing jointly.

To claim the deduction, you’ll need to file IRS Form 4797 with your tax return. You’ll also need to attach a statement that provides information about the computation of your loss.

Summary

As we stated at the outset, Section 1244 lets small business owners claim an ordinary loss on the sale or exchange of stock. To qualify for this favorable tax treatment, the stock issuance must come from a qualified small business, and it must’ve been acquired when the stock was originally issued directly from the issuing corporation.
In addition, the shareholder must hold the stock continually since the date the stock was issued for more than one year at the time of sale or exchange. If you meet all of these requirements, you can claim an ordinary loss on up to $50,000 of eligible small business stock each year, or $100,000 if filing jointly. This can be a valuable tax break for small business owners, so be sure to take advantage of it if you’re eligible.

Written by Sandra Habiger, CPA

Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.

Written by Sandra Habiger, CPA

Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.