Loss on Small Business Corporation Stock

Conclusions

Pursuant to Section 1244 of the Internal Revenue Code of 1986, as amended, up to $100,000 of the loss on the sale of stock (which includes the stock becoming worthless) of a Small Business Corporation in any one tax year can be treated as an Ordinary Loss and deducted in full against Ordinary Income. If the loss exceeds the Section 1244 limit, the excess will be a Capital Loss.

To report a loss on the sale or exchange of Section 1244 Stock,

• Report the ordinary loss portion on IRS Form 4797, Part II
• Report the balance of the loss that exceeds the 1244 loss maximum (capital loss portion) on IRS Form 8949

Discussion – Applies to Stock issued after November 6, 1978

1. Loss Treated as Ordinary Loss; not Capital Loss (1244(a)). For an individual, a loss on section 1244 stock issued to such individual or to a partnership which but for this section would be treated as a loss from the sale or exchange of a capital asset shall be treated as an ordinary loss subject to the limitations specified in Section 1244 of the Internal Revenue Code of 1986, as amended.

2. Treasury Regulations Section 1.1244(a)-1. To claim a Section 1244 loss, the individual or partnership must have held the stock continuously from date of issuance by the corporation to the date of the loss. Stock acquired from anyone other than the corporation issuer cannot be Section 1244 Stock.

3. Small Business Corporation (1244(c)(3)). A corporation is a “Small Business Corporation” if at the time the subject stock was issued, the corporation had not received (in the aggregate) more than $1million in exchange for issuance of its stock. The value received for stock issued in exchange for property other than money shall be the adjusted basis of the property received by the corporation at the time of the exchange.

4. Section 1244 Stock (1244 (c)(1)). 1244 stock means stock in a domestic corporation that was issued directly to the shareholder out of authorized but unissued stock, if at the time the subject stock was issued to the individual or partnership,
   1. the issuer was a Small Business Corporation,
   2. the stock was issued in exchange for money or other property (but not stock or securities), and
   3. if during the five most recent tax years ending before the date the loss was incurred, the corporation derived more than 50% of its aggregate gross income from sources other than royalties, rents, dividends, interest, annuities, and sales or exchanges from stocks or securities.
   4. There are special rules for corporations that were not in existence for at least 5 years and for stock issued before November 6, 1978.

5. Treasury Regulation 1.1244(c)-1(b). Only common stock can be Section 1244 Stock.

6. Treasury Regulation 1.1244(a)-1. The stock becoming worthless or subject to liquidation of the corporation is treated as a sale or exchange for claiming a Section 1244 loss. Transfer to a bankruptcy trustee is not a sale or exchange for purposes of Section 1244.

7. S-Corp Observation. An S-Corp may qualify as a Small Business Corporation, however, it is unlikely that Section 1244 will be of much value to the S-Corp shareholder because operating losses passed through to the shareholder will likely have already reduced his basis to or near zero.

8. Treasury Regulations Section 1244(d)-3. Stock received in a sale or exchange of 1244 Stock in a transaction that qualifies as a tax-free reorganization pursuant to the Internal Revenue Code of 1986, as amended, under Section 368(a)(1)(E), recapitalization, or under Section 368(a)(1)(F), a mere change in identity, form, or place of organization will retain its character as Section 1244 Stock.

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