With the end of the year rapidly approaching, now is the time to be looking at tax savings moves. With the massive changes to allowable tax deductions over the past year, many individual taxpayers are looking for new ways to save tax dollars. One of the traditional tax planning strategies involves harvesting capital gains and losses from investment positions. While this is a great planning tool, any benefits to be received will only be realized at the tax rate applicable to capital gains – 20% in most situations. Further, capital losses in excess of capital gains are limited in the amount that can be deducted against other ordinary income.
When it comes to investments in small businesses, generally speaking, they too are considered capital assets, subject to the rules discussed above related to capital gains and losses. However, there is a provision under IRC Section 1244 that allows an ordinary loss deduction of up to $50,000 ($100,000 if a joint return is filed) per year from the disposition of small business stock, provided certain requirements are met. This provides a huge benefit for qualifying taxpayers as that ordinary loss can be used to shelter wages, interest and dividends, and other sources of ordinary income.
What are the Requirements of Section 1244?
In order to deduct a loss from the sale or exchange of business stock under IRC Section 1244, there are two main requirements that must be met –
- The stock must have been issued by a qualifying small business corporation
- The stock must have been issued to an eligible investor.
What is a Qualifying Small Business Corporation?
In order for a loss on the sale or exchange of stock to be eligible for the ordinary loss deduction under Section 1244, it must have been issued by a qualifying small business corporation. A qualifying small business corporation is one that meets the following requirements:
- The stock must have been issued by a domestic corporation, including an S corporation.
- At the time the stock was issued, the aggregate amount of money or other property (other than stocks or securities) received in exchange for stock, as a contribution to capital and as paid-in surplus does not exceed $1,000,000.
- The corporation must have derived more than 50% of its aggregate gross receipts from sources other than royalties, rents, dividends, interest, annuities, and sales or exchanges of stocks or securities during the 5 most recent taxable years ending before the date the loss on the sale or exchange of the stock was sustained.
Who is Considered an Eligible Investor?
Individuals and partnerships (including LLCs that have elected to be taxed as partnerships) qualify as eligible investors for the benefits under Section 1244. In the context of a partnership or an LLC, the loss deduction is determined at the entity level and is then passed through to the individual owners to be reported on their personal tax returns.
What are the Benefits and Limitations of a Section 1244 Loss?
Investors are permitted to claim an ordinary loss, rather than a capital loss, on the sale or exchange of qualifying stock. Worthlessness of qualifying stock also qualifies for this beneficial treatment. However, when a stock becomes worthless is not always black and white. While the determination of worthlessness of a stock is subjective, a sale of the shares to an unrelated third party, even if for a nominal amount, would help support a loss deduction in the year of sale. In order for the loss to be respected, however, the sale must be a bonafide sale.
Any eligible Section 1244 loss in excess of the annual limitation discussed above is treated as a capital loss, subject to the rules applicable to capital losses. From a planning standpoint, to the extent the potential loss under Section 1244 exceeds the annual limitation, consideration should be given to disposing of the stock over two or more years in order to maximize the ordinary loss deduction.
If you believe that you own stock in a corporation that is eligible for Section 1244 treatment you are encouraged to reach out to your tax adviser to discuss the potential for claiming an ordinary loss deduction prior to the end of current tax year.