As an investor, it is important to not overlook important tax incentives. There are some scenarios where you know that there will be a loss upon sale or disposition of stock, so taking the time to fully understand the tax consequences will help you produce efficient tax results. The following is a deep dive into the potential advantages you can obtain through Section 1244.
What is Section 1244 and How Does Someone Qualify?
Section 1244 of the Internal Revenue Code allows individual taxpayers and partnerships (with individual partners) to treat losses on the sale or exchange of Qualified Small Business Stock (QSBS), which would otherwise be treated as a capital loss, as an ordinary loss.
Corporations, trusts, estates, and S Corporations cannot claim tax benefits for losses on QSBS under Code Section 1244. S Corporation shareholders may claim a loss under Section 1244 if the S Corporation stock itself qualifies and is disposed of at a loss.
For stock to qualify for §1244 treatment, the following must apply:
- The stock must be in a domestic Corporation and it cannot be an LLC that elected corporate tax status.
- The corporation must be a small business corporation (at time of issuance). For the purposes of §1244, a corporation is considered a small business corporation if the aggregate amount of money and other property received by the corporation for stock, as either contribution to capital or as paid-in surplus, does not exceed $1,000,000. The determination is made when the stock is issued and if property is received, additional rules apply.
- The corporation must be an operating company, not a holding or investment company — the corporation must derive more than 50% of its aggregate gross receipts from sources other than the following: royalties, rents, dividends, interests, annuities, and the sale or exchanges of stocks or securities. This test is measured during the five most recent taxable years ending before the date of the loss on the stock. If the corporation has not been in existence for at least five years, other rules apply. Additionally, this test does not apply if gross deductions exceed gross income during the five-year period.
- The stock must have been issued for money or other property (excluding stock and securities). If stock was issued in exchange for property, limitations on the amount of ordinary loss available would apply if the property had basis in excess of its fair market value. Stock issued in exchange for services does not qualify.
- The stock must be acquired at original issuance and ownership must be uninterrupted until the sale or exchange.
What are the Tax Benefits?
The total amount of §1244 losses that can be taken during a taxable year are limited to $50,000 or $100,000 if Married Filing Jointly (MFJ). Any losses above the limit are treated as capital losses. With respect to partnerships, these limits apply separately to each individual partner.
As an ordinary loss, Section 1244 losses are treated as losses attributable to the taxpayer’s trade or business. As such, these losses are included in the calculation of the net operating loss deduction without being limited by nonbusiness income. Additionally, these losses, although capped at $50,000/100,000 MFJ under the Code Section, greatly exceed the $3,000 capital loss annual limitation.
Tax Planning Considerations
The list below, while not exhaustive, highlights a few tax planning ideas to consider when dealing with QSBS and Section 1244:
- If the loss potentially exceeds the $50,000/100,000 MFJ cap, perhaps the stock could be disposed of over multiple years to maximum the ordinary loss benefit.
- Regarding the original issuance requirement, partnerships cannot distribute stock to its partners to then claim a loss on the sale or exchange of stock.
- If stock is held through a partnership, the loss is only deductible for individuals who were partners when the stock was first acquired and disposed.
- If a corporation is offering to issue someone stock in exchange for services, they will not be eligible for Section 1244 treatment. Instead, the corporation should pay cash for services and then allow the service provider to purchase stock, if so desired.
- It is important to note that the sale or exchange of stock includes stock being deemed worthless.
- If you own stock that potentially qualifies as 1244, make sure you keep adequate records to be eligible to claim the tax benefits. If you believe you are buying stock that may eventually qualify for §1244 treatment, ask the company to certify that it meets those qualifications now.
Section 1244 has additional limitations beyond the scope of this article. If you plan to invest in small businesses, please reach out to our SC&H Tax team to ensure you are taking advantage of any potential tax saving opportunities. We can help you maintain proper documentation and plan your exits to maximize tax savings.
Want to Capitalize on Additional Tax Planning Opportunities?
Additional information regarding Qualified Small Business Stock can be found in our earlier Articles — Investing Insights Parts 1 and 2.
- Investing for Success Part 1 of 3: Gain Exclusion Under Section 1202
- Investing for Success Part 2 of 3: Gain Deferral Under Section 1045
If you plan to invest in small businesses, contact your tax advisor to make sure you are taking advantage of any potential tax saving opportunities.