What Is a Section 1244 Stock?

Section 1244 stock refers to the tax treatment of restricted stock by the IRS. Section 1244 of the tax code allows losses from the sale of shares of small, domestic corporations to be deducted as ordinary losses instead of as capital losses up to a maximum of $50,000 for individual tax returns or $100,000 for joint returns.

Key Takeaways

  • Section 1244 stock refers to the tax treatment of qualified restricted shares.
  • Section 1244 stock allows firms to report certain capital losses as ordinary losses for tax purposes.
  • This lets new or smaller companies take advantage of lower effective tax rates and increased deductions.

The Basics of Section 1244 Stock

Startups and small businesses are risky endeavors. Section 1244 provides an important benefit by allowing certain capital losses to be treated as ordinary losses. Ordinary losses are fully deductible in the year of the loss rather than being subject to an annual limit. Moreover, ordinary losses are not offset by capital gains. This means that firms can still enjoy the lower tax rate associated with capital gains which may have otherwise been netted out against a capital loss. At the same time, ordinary taxable income can be netted by ordinary losses which reduces taxable income.

Any loss that qualifies as an ordinary loss under Section 1244 is also classified as a trade or business loss in computing an individual’s net operating loss (NOL). Therefore, Section 1244 losses are allowed for NOL purposes without being limited by non-business income.

Qualifying for Section 1244 Stock

To qualify for section 1244 treatment, the corporation, the stock, and the shareholders must meet certain requirements.

  • The stock must be issued by U.S. corporations and can be either a common or preferred stock. However, if the shares in question were issued before July 19, 1994, only common stock qualifies.
  • The corporation's aggregate capital must not have exceeded $1 million when the stock was issued and the corporation cannot derive more than 50% of its income from passive investments.
  • The shareholder must have purchased the stock and not received it as compensation.
  • Only individual shareholders who purchase the stock directly from the company qualify for the special tax treatment.
  • A majority of the corporation's revenues must come directly from operations. In other words, most income cannot be attributed to interest, dividends, royalties, etc. To have this exception apply - i.e. it must be run as an operating company.
  • Shares must be held continually since the date the stock was issued and not exchanged in the market or through private transactions.

Exclusion of Section 1244

Section 1244 does not apply to any contributions made after the initial shares are issued. However, later contributions can qualify if the investor receives shares that were authorized, but not issued. The Section 1244 stock should be issued pursuant to a written corporate resolution. A loss can be claimed by individual shareholders as a Section 1244 stock loss on Form 4797, Sales of Business Property and must be filed with the shareholder's individual income tax return.