A Section 1244 stock is a type of equity named after the portion of the Internal Revenue Code that describes its treatment under tax law. 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.
Startup small businesses are risky endeavors, but a Section 1244 stock provides an important benefit. Under Section 1244, losses that would otherwise be treated as capital losses are treated as ordinary losses. This has several advantages to the individual:
- Ordinary losses are not limited to $3,000 per year. Rather, ordinary losses are fully deducted in the year of the loss.
- Ordinary losses are not netted with capital gains that are subject to a maximum tax rate of 20%. Therefore, if you have capital gains in the same year you have ordinary losses, you can still enjoy the capital gains rates.
- Ordinary losses offset other sources of income that is taxed at ordinary rates.
Also, any loss that qualifies as an ordinary loss under Sec. 1244 is also classified as a trade or business loss in computing an individual’s net operating loss (NOL). Therefore, Sec. 1244 losses are allowed for NOL purposes without being limited by nonbusiness income.
Normally, stocks are treated as a capital asset. When sold or otherwise disposed of at a loss, the loss is deducted as a capital loss, meaning they are subject to an annual deduction limit of only $3,000. Excess losses over $3,000 are required to be carried over to the next year.
Qualifying as a Section 1244 Stock
To qualify for section 1244 treatment, the corporation, the stock and the shareholders must meet certain requirements.
- The stock must come from a domestic corporation. Only stock (including preferred stock) of a domestic corporation can qualify as section 1244 stock. If the stock was issued prior to July 19, 1994, the stock must be common stock.
- The corporation's aggregate capital must not have exceeded $1 million when the stock was issued and the corporation must not derive more than 50% of its income from passive investments.
- The shareholder must have paid for 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.
- Most of the company's gross receipts must be from operations. For a period of the corporation's most recent five years ending before the date of the loss, gross receipts from royalties, rents, dividends, interest, annuities, and sales or exchanges of stock or securities must not exceed 50% of the receipts of the company. If the company has been in business less than five years, the testing period applies to all the years the company has been in existence. This gross receipts test does not apply, however, if during the applicable period, the aggregated amount of deductions exceeds the aggregate amount of gross income. To have this exception apply, the company must be an operating company; it can't be an investment company.
- As owner of the 1244 stock, you must be an individual, or a partner in a partnership, which holds 1244 stock.
- You must have acquired the stock after June 30, 1958.
- If the stock was acquired before November 7, 1978 the stock was issued under a written plan that met the requirements of section 1244.
- You have held the stock continually as an individual, or partnership, since the date the stock was issued.
- If all of these requirements are met, you should report the loss, up to the maximum limitation, on line 10 of Form 4797. You should report any loss in excess of the limit on Schedule D, Form 1040.
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.