When a loss on sale or exchange of stock occurs, it is usually considered a capital loss, and capital loss treatment is generally less advantageous than ordinary deduction treatment. A capital loss recognized by an individual is applied first against capital gain—which is usually subject to tax at a maximum marginal rate which is lower than that on ordinary income—and, to the extent it exceeds capital gains recognized during the year, is then subject to limitations on deductibility.
A solid tax strategy often involves minimizing capital loss deductions and maximizing capital gain income, while converting capital losses into ordinary losses when possible. So, we’ve set out to share how the tax law under Internal Revenue Code Section 1244 (“Section 1244”)—an often-overlooked special exception—can help those qualified, accomplish just that.
Criteria for Section 1244 Stock Loss Tax Treatment
The tax law under Section 1244 fortunately allows ordinary loss treatment of certain losses with respect to stock of small corporations, also known as qualified small business stock (QSBS). In general, this special treatment is only available if the following conditions are satisfied:
- As of the time the stock was issued, the aggregate amount that was received by the issuing corporation for stock, as contributions to capital and as paid-in surplus, must not have exceeded $1 million.
- The stock must have been issued for money or property (other than stock or securities). Thus, the stock can’t be issued as compensation for services. Stock received in certain corporate reorganizations will also qualify. The stock can be common or preferred stock and stock in an S corporation.
- For the five years before the year the loss was sustained, the corporation must not have received 50% or more of its receipts from certain passive sources.
- The taxpayer claiming the special treatment must be an individual (including, if certain conditions are satisfied, individuals who claim the loss through holding an interest in a partnership that is selling the stock). However, this special treatment isn’t available to corporations, trusts, or estates.
- The stock must have been issued to the individual claiming special treatment, or to the partnership through which the individual is claiming special treatment and held continuously by that individual (or partnership) to the time of sale.
In any year, the total loss treated as ordinary under these rules can’t be more than $50,000 (or $100,000 if you file a joint return).
Tax Planning Idea
A tip here is to sell loss stock over multiple years to maximize the tax benefits of IRC 1244. There is no formal election needed, you simply treat the relevant portion of the loss as ordinary in the year of the disposition.
For other tips and insights on Section 1244 and other tax planning opportunities, explore our other “Investing for Success” three-part series.
- Investing for Success Part 1 of 3: Gain Exclusion Under Section 1202
- Investing for Success Part 2 of 3: Gain Deferral Under Section 1045
- Investing for Success Part 3 of 3: Losses on Small Business Stock Under Section 1244
As previously mentioned, this special exception to the capital loss rules is not always known or applied, and we see it is missed quite often when S corporation stock is involved. If you have an expected loss from the disposition of a small business, be sure you explore Section 1244 as a viable option. If you’d like to speak with a member of our SC&H Tax team to discuss planning ideas around that disposition to create the maximum tax benefit, send us a message.