Getting Maximum Value from Small Business Stock Losses

When an individual sells a stock for a loss, it is a capital loss, and Congress makes it difficult for individuals to use their capital losses.

The tax law only allows capital losses to the extent of capital gains. If capital losses exceed capital gains, the individual can only use up to $3,000 per year against ordinary income ($1,500 if married filing separately).

However, there is a way around this rule: Losses on Section 1244 stock are ordinary losses, and claiming this valuable tax benefit allows an individual to save thousands of dollars in tax in the year of sale compared to the standard capital loss treatment.

Let’s review what qualifies as Section 1244 stock, what benefits a taxpayer can get from Section 1244 stock, and how to claim those benefits on a tax return.

Section 1244 Stock Defined

There are four requirements to qualify as Section 1244 stock:[1]

1. A domestic corporation issues the stock;
2. The stock is issued for money or other property (not stock and securities);
3. The corporation must have aggregate capital contributions of $1 million or less at the time of stock issuance;
4. The corporation must derive at least 50 percent of its gross receipts from business activities, and not passive investment income, for the five-taxable-year period ending before the date of the stock loss.

The gross receipts requirement does not apply if the corporation’s cumulative deductions (excluding the net operating loss carryforward and carryback deduction and the dividends-received deduction) exceed its cumulative gross income during the five-year period preceding the stock loss.[2]

In addition, if the corporation was not in existence for the five-taxable-year period ending before the date of the stock loss, then use the period of the tax years ending before that date. If the corporation does not exist for one tax year before the date of the stock loss, then use the period of existence.[3]

Both C corporations and S corporations can issue Section 1244 stock. In Private Letter Ruling (PLR) 913003, the IRS stated, “Neither the legislative history nor the regulations under Section 1244 provide support for distinguishing between Subchapter C and Subchapter S corporations in determining eligibility for the ordinary loss deduction under Section 1244.”

Section 1244 Benefits and Limitations

If an individual or a partnership sells Section 1244 stock, then the individual or partner who is an individual can treat up to $50,000 of the stock loss as an ordinary loss ($100,000 if married filing jointly).[4] There is no income limitation on this tax benefit.

The Section 1244 ordinary loss is a business loss for net operating loss (NOL) purposes; therefore, the loss can generate an NOL that carries forward (or carries back if a farming business).[5]

Several provisions limit who can use Section 1244 and the amount of the loss that can be recharacterized as ordinary under Section 1244.

S corporations cannot pass Section 1244 stock losses to individual S corporation shareholders; those losses are capital to the shareholders.[6] Also, the Section 1244 ordinary loss benefit only applies to the individual shareholders originally issued the stock.[7]

If a corporation issues Section 1244 stock in exchange for property that, immediately before the exchange, has an adjusted basis (for determining loss) in excess of its fair market value, then for purposes of Section 1244, the stock basis reduces by the amount by which the adjusted basis of the property exceeds its fair market value.

If, after the stock issuance, there is, for any reason, an increase in the basis of Section 1244 stock (including S corporation pass-through items), that increase is allocable to stock that is not Section 1244 stock. Therefore, in this case, the taxpayer must apportion a loss on the stock between the part that qualifies as Section 1244 stock and the part that does not qualify as Section 1244 stock.[8]

Section 1244 Reporting

The Section 1244 ordinary loss report is on line 10 of Form 4797, Sales of Business Property, and any additional capital loss exceeding the allowed ordinary loss is on Form 8949, Sales and Other Dispositions of Capital Assets, using code “S”[9].

Example 1. Simon, who is unmarried, capitalized Quail Corp. with $100,000 and received 1,000 shares of C corporation stock. Quail Corp. engaged in a trade or business activity and did not succeed. Three years later, in tax year 2022, Simon liquidated the C corporation and received $40,000, which generated a $60,000 loss.

Amounts a shareholder receives in a liquidating distribution are full payment in exchange for the stock.[10] The Quail Corp. stock is Section 1244 stock, so $50,000 of the $60,000 loss is an ordinary loss, while the remaining $10,000 is a capital loss.

The Form 4797 entry is as follows:

The Form 8949 entry is as follows:

Section 1244 Planning

Below are additional examples demonstrating Section 1244 stock planning opportunities (and potential problems to avoid).

Example 2.[11] Alice (married), Bob (unmarried), and the Coral Trust are equal partners in a partnership that is Section 1244 stock. Neither Alice nor Bob has other Section 1244 stock.

If the partnership sells the Section 1244 stock for a $300,000 loss, Alice, Bob, and the Coral Trust distributes $100,000 of the Section 1244 stock loss to each. Alice can treat all $100,000 as an ordinary loss, and Bob can treat $50,000 as an ordinary loss and $50,000 as a capital loss. The Coral Trust is not an individual, so it must treat all $100,000 as a capital loss.

If the partnership distributed the stock to Alice, Bob, and the Coral Trust, and the partners sold it, the stock would not qualify for Section 1244 treatment for Alice and Bob since they did not acquire the stock by issuance from the qualifying corporation.

Example 3.[12] For $10,000, Brass Corp. issues 100 shares of Section 1244 stock to Xavier. Xavier later contributes $2,000 to the corporation’s capital, increasing the total basis of his 100 shares to $12,000. Subsequently, he sells the 100 shares for $9,000.

Of the $3,000 loss, $2,500 allocates to the portion of the stock that qualifies as Section 1244 stock ($10,000/$12,000 of $3,000), and the remaining $500 goes to the stock portion that does not qualify. Therefore, Xavier can treat $2,500 as an ordinary loss and $500 as a capital loss.

If Xavier had instead contributed $2,000 in exchange for 20 additional shares of original issue stock, the entire $3,000 loss could have been an ordinary loss.

Example 4.[13] Barbara transfers property with an adjusted basis of $100,000 and a fair market value of $25,000 to a corporation for 1,000 shares of Section 1244 stock in an exchange tax-deferred under Section 351. The basis of Barbara’s stock is $100,000 ($100 per share), but solely for purposes of Section 1244, the total basis of the stock must reduce by $75,000, the excess of the adjusted basis of the property exchanged over its fair market value.

So, the basis of such stock for purposes of Section 1244 is $25,000, and the basis of each share for such purposes is $25. If Barbara sells the 1,000 shares for $20,000 six years later, then $5,000 of her total loss of $80,000 is an ordinary loss under Section 1244, after satisfying the various requirements. The remaining $75,000 will be a capital loss.

By contributing loss property to a corporation in a tax-deferred Section 351 exchange, Barbara “trapped” the loss in her corporation stock basis and deferred a loss for six years. If she instead sold the property and contributed the $25,000 cash sale proceeds, she would have an immediate $75,000 capital loss she could use or carry forward, and the entire $25,000 in corporation stock basis is eligible for the Section 1244 ordinary loss treatment if she meets all other requirements.

Summary

No one wants to lose money in a business; however, it can happen for many reasons.

If there is a risk that a planned business could be a losing venture, it is worthwhile to capitalize the corporation in such a way as to preserve the right to use Section 1244 to claim ordinary losses instead of capital losses on the sale or liquidation of the corporation.

Don’t forget that S corporation stock can qualify as Section 1244 stock. Many often believe that only C corporation stock can qualify. Since S corporations are one of the most common choices for tax entity type, millions of taxpayers may be eligible for this benefit but not know about it.