Section 1244 stock is the first $1 million of stock issued by qualified corporations to individuals or partnerships as described in section 1244 of the IRS code. Losses on 1244 stock can be reported as ordinary losses instead of capital losses upon disposition.
What Is 1244 Stock and How Are Losses Reported?
Stock is ordinarily considered a capital asset, which would result in a capital loss if the stock was disposed of after a decline in value. Being able to take an ordinary loss on disposal of stock results in preferred tax treatment for 1244 stock. The ordinary loss would be claimed by filing Form 4797, and any excess capital loss is reported on Schedule D. The rules regarding excess capital loss are explained in further detail later.
The IRS allows for this special tax treatment to promote small business investment. By putting tax relief measures in place for small business failure, investors may have less apprehension regarding the inherent risk of small business investment.
Key Takeaways:
- 1244 stock can only be issued by a domestic C or S corporation.
- 1244 stock can result in an ordinary loss of up to $50,000 for single filers and $100,000 for those married and filing jointly.
- Section 1244 promotes small business investment by maximizing deduction opportunities in the event of a loss on stock disposal.
Section 1244 Stock Criteria
Generally, Section 1244 stock is the first $1 million of stock issued to individuals or partners by a qualified small business corporation.
Here are the qualifying criteria for section 1244 stock:
$1,000,000 or Less Received for Stock
The value of money and property received by the corporation for the issuance of the stock cannot be greater than $1 million, including contributions and paid-in-capital. Alternatively, the FMV of the stock the corporation issued cannot exceed $1,000,000 in total issuance to all owners. This limitation is in place to ensure that the issuing entity is a small business corporation.
After a corporation has reached $1,000,000 in stock issuance, it is no longer able to issue section 1244 stock. However, in the year that the $1,000,000 cap is reached, the corporation may elect to designate a portion of its stock as 1244 stock, subject to limitations.
Stock is Issued for Cash or Property—Not Services
Only cash or property can be provided to obtain the Section 1244 stock, so stock issued in exchange for services does not qualify. Section 1244 stock generally may not be obtained in exchange for other stock. However, there are certain exceptions for pre-existing stock exchanged for new section 1244 stock.
Shareholder Must be the Initial Owner of the Stock
The shareholder must be the initial owner of the stock and not have obtained the stock on the secondary market. Note that if a partnership owns 1244 stock and distributes it to partners, the distributed stock no longer qualifies as 1244 stock because the new partners are considered secondary owners.
Stock is Owned by Individuals or Partnerships
Only individuals or partnerships can own section 1244 stock. The stock can be common or preferred Preferred stock is permitted as long as it was issued after July 18, 1984. , but not convertible.
Stock is Issued by Domestic C- or S-corp
Entities issuing stock must be domestic corporations. S-corps are eligible for section 1244 treatment. Entities issuing 1244 stock must also pass a gross receipts test showing their passive income is less than 50%.
Issuing entities must be operating companies without dependence on passive income. This is determined through the gross receipts test. In the test, in the five years preceding the 1244 stock loss, the issuing company must have obtained no more than 50% of its income from the following sources:
- Dividends
- Interest
- Royalties
- Annuities
Additional details can be found in IRS Publication 550.
How Do Section 1244 Losses Work?
Traditionally, since stock is a capital asset, sale of stock at a loss would result in a capital loss. A capital loss can be used to offset capital gains from the same year.
- If capital losses remain after offsetting capital gains, $3,000 of the remaining capital losses can be deducted against ordinary income Ordinary income includes short-term capital gains, rent, royalties, interest, dividends, salaries, etc. each year until the capital losses are fully absorbed.
- If the capital loss is large and the taxpayer has limited capital gains, it could take a number of years before the capital loss is depleted.
In contrast, an ordinary loss can be deducted directly against ordinary income. Since ordinary income is generally taxed at higher rates, an ordinary loss generally saves more taxes than a capital loss. In addition, there is no limitation on the amount of ordinary losses that can be deducted in a year.
One of the key characteristics of 1244 stock is the unusual ability to take an ordinary loss on the disposition of stock.
Section 1244 Loss Limitations
Section 1244 losses are treated as ordinary losses and permitted up to $50,000 per year for single filers and $100,000 for joint filers. The $100,000 limit applies to joint filers even if only one spouse had the loss. Losses in excess of the limits are treated as capital losses.
For example, if an individual filing a joint return had a Section 1244 loss of $150,000 in 2023, $100,000 of ordinary loss could be taken on the 2023 return, and $50,000 would be a capital loss.
Examples of Section 1244 Losses
To further clarify how section 1244 losses work, here are two examples:
Example 1: Individual Investor – Filing Single
Stella Stockholder bought $45,000 worth of stock from a small corporation that meets the IRS criteria for Section 1244. Stella waits six years for the company to turn a profit and then reluctantly sells her shares for $5,000 in 2024.
Loss Calculation:
- Sale Proceeds: $5,000
- Adjusted Basis: $45,000
- Loss: $5,000 – $45,000 = ($40,000) ordinary loss
Stella can deduct a $40,000 ordinary loss in full for the year 2024 since it is less than the $50,000 section 1244 loss limitation for single filers.
Example 2: Married Investors – Married Filing Jointly
Bob and Brenda Banks purchased $210,000 of qualifying section 1244 stock. In 2024, two years after purchase, they decided to sell their stock, which had declined significantly in value to $30,000.
Loss Calculation:
- Sale Proceeds: $30,000
- Adjusted Basis: $210,000
-
Losses: $30,000 – $210,000 =($180,000) total loss($100,000) ordinary loss($80,000) capital loss
Bob and Brenda can deduct a $100,000 ordinary loss in full in 2024. The remaining $80,000 capital loss can 1) offset capital gains in 2024; 2) offset future capital gains and; 3) be deducted in $3,000 annual increments until the total $80,000 has been absorbed.
How to Report Section 1244 Loss
An ordinary section 1244 loss is reported on Form 4797 and filed with the shareholder’s personal income tax return. Here are the steps to reporting a Section 1244 loss:
- Step 1: Calculate the loss by subtracting the adjusted basis from the proceeds, as demonstrated in the previous examples.
- Step 2: Report the ordinary loss (up to $50,000 single or $100,000 married) on line 10 of Form 4797.
- Step 3: Report any capital loss (the loss exceeding the ordinary loss limits) separately on Form 1040, Schedule D.
After reporting the loss, be sure to retain copies of documentation supporting the corporation’s qualification under Section 1244. Your records should also support the dollar amount of the loss claimed.
Section 1244 Loss Recordkeeping Recommendations
To support the Section 1244 status reported, adequate corporate records should be maintained to substantiate the stock’s qualification under Section 1244. Here is a list of recommended documents to retain:
- Date of stock issuance
- Name and identifying information for recipients of the stock
- Detail of what the corporation received for each stock issuance
- Basis and fair market value information for any property received by the corporation for stock
- Documents such as tax returns or financial statements that show 5 immediately preceding years of tax returns,
Frequently Asked Questions (FAQs)
Section 1202 provides potential tax savings on gains from the sale of small business stocks, while section 1244 provides tax relief for losses from small business stocks. While both code sections refer to “Qualified Small Businesses,” the definitions of qualified small businesses for each section are completely different.
Section 1244 stock is considered worthless when the shares no longer hold value. This generally comes as a result of corporate collapse or deterioration.
When section 1244 stock is sold for a gain and held for more than a year, it is treated as a capital gain, resulting in lower tax rates than if the gain was taxed at ordinary income rates. If the stock is held for more than five years, the gain might be excluded if the corporation meets the rules of section 1202. Stock held for a year or less is taxed at ordinary income rates.
Bottom Line
Section 1244 of the IRS code provides relief to shareholders in small corporations, allowing an ordinary loss. Worthless section 1244 stock and 1244 stock sold at a loss result in ordinary losses. These can be used to offset higher taxed income.
The loss is taken on the shareholder’s personal tax return. Ordinary losses are limited to $50,000 for single filers and $100,000 for couples filing jointly. This IRS provision can provide a significant tax liability reduction for individual investors in high-risk small business endeavors.
