Section 1244 of the tax code encourages new investment in small businesses by permitting investors to claim an ordinary loss on disposition (including worthlessness) of eligible small business stock. The maximum deductible ordinary loss under Section 1244 is limited to $50,000 per year ($100,000 for married filing joint). If the loss exceeds the annual deductible limit, the excess is classified as a capital loss subject to the capital loss rules and limitations.

To qualify under Section 1244, the small business stock must comply with certain requirements when issued and in the year the stock is disposed at a loss. The requirements at issuance include:

• The corporation must be a domestic corporation;
• The cumulative amount of money and property received by the corporation for the stock must be $1 million or less;
• The stock must be issued in exchange for cash or other property (not for stock, securities, or in exchange for services provided);
• The stock must be issued directly to the original owner (i.e., a taxpayer who purchases an existing company via a stock purchase is not eligible for Section 1244 because they would not be the original owner of the stock);
• The original owner must be an individual or partnership; and
• The stock can be either common or preferred stock issued after July 18, 1984.

The requirements in the year the stock is disposed at a loss include:

• During the five most recent tax years before the loss, the corporation must have derived more than 50% of its gross receipts from sources other than royalties, rents, dividends, interest, annuities, and gains from sales and trades of stocks and securities;
• If the corporation was in existence for at least a year, but less than five year, the 50% gross receipts test applies to all the tax years ending before the loss;
• If the corporation was in existence less than a year, the 50% gross receipts test applies to the entire period of the corporation’s existence; and
• The corporation must be largely an operating company during the gross receipts testing period, not merely a holding or investment company.

To take advantage of the Section 1244 stock loss, it is important that both the shareholder and the corporation keep adequate records. The shareholders need to track Section 1244 stock and non-Section 1244 stock in the same corporation separately. Corporations should maintain the following records:

• The names of the person to whom Section 1244 stock was issued;
• The date that Section 1244 stock was issued;
• A description of the amount and type of consideration received by the corporation from each shareholder (if property was received, the corporation should document the shareholder’s adjusted basis and the fair market value of the property when received by corporation);
• A breakdown of money and basis in the hands of the corporation of property received in exchange for stock, as a contribution to capital or as paid-in surplus;
• Information regarding any tax-free stock dividends or tax-free reorganizations; and
• Tax returns for the five most recent years preceding the year in which a shareholder claims a Section 1244 loss in order to substantiate the gross receipt test requirement.

Taxpayers who invest in small business stock that qualifies for Section 1244 have a significant advantage if the stock is sold at a loss. Contact Flexible Accounting Services of the Triangle today to see if you can benefit from Section 1244.