Section 1244 Stock: Turn Losses Into Tax

Investing in small businesses can be rewarding, but let's face it, sometimes things don’t go as planned. When faced with potential losses, understanding Sec. 1244 stock can turn a disappointing investment into a strategic tax advantage. We’re here to help you understand the ins and outs of Sec. 1244 stock, and how losses from these investments can be transformed into tax savings.

Overview

Ordinary Loss Treatment: Section 1244 stock allows investors to deduct losses as ordinary losses instead of capital losses.
Deduction Limits: Individuals can deduct up to $50,000 per year and joint filers up to $100,000.
Qualifying Stock: Must be originally issued by the corporation for money or property, not services or transfers.‍
Reporting & Records: Losses are reported on Form 4797, with proper documentation required to support the deduction.

Table of Contents

What is Section 1244 Stock?

Section 1244 stock, known as small business stock, is stock issued after November 6, 1978 that meets the following qualifications:

The stock is issued directly from the corporation in exchange for money or property
🔑 Stock issued in exchange for services is not Section 1244 stock
The issuing corporation must a 1244 small business corporation: the aggregate amount of money and other property received by the corporation cannot exceed $1M
The corporation’s revenue must come mostly from operations; The corporation cannot derive more than 50% of its gross receipts from passive sources (ex: interest income, dividend income, royalties)

What are Section 1244 Stock Losses?

When you have a loss from the sale, exchange, or worthlessness of eligible small business stock (1244 stock), you may be able to enjoy preferential tax treatment by characterizing that loss as an ordinary loss instead of a capital loss.

Ordinary losses from the sale of small business stock are subject to limitations…. → Ordinary loss deductions on 1244 small business stock can reduce taxable income for a maximum of $50,000 ($100,000 for married filing joint returns) in a tax year.

When Can Losses from Small Business Stock Benefit You?

Planning Tip: Spreading Losses

Because ordinary loss treatment is capped at $50,000 ($100,000 if married filing jointly) per year, some investors time stock sales across multiple tax years. This way, they can maximize the deduction by staying under the annual limit each year instead of taking one large loss all at once.

Normally, capital losses from the sale of stock are only allowed to be deducted to the extent of capital gains. In the event that capital losses exceed capital gains, an ordinary loss is available up to $3,000 and any remaining capital losses are carried forward. The benefit of Section 1244 is that losses from the sale of small business stock are treated as ordinary losses and can be taken as a deduction even if no capital gains are recognized.

Special Basis Rules

If you buy Section 1244 stock with cash, your basis is simply the amount you paid. But if you receive stock in exchange for property, your basis is limited to the property’s fair market value at the time of contribution, even if your adjusted basis was higher. This rule prevents inflated losses and ensures fair treatment.

Example: You invest $20,000 into a qualified small business corporation after the initial shares of the company are issued. In May, 2022, the value of your investment in the company has gone down to $5,000 and you sell your shares for a $15,000 loss.

If this stock qualifies as 1244 small business stock:

This ordinary loss will reduce your taxable income by $15,000.

If this stock does not qualify as 1244 small business stock:

Only $3,000 of the $15,000 loss will be deducted against ordinary income and
You will have a $12,000 loss carry-forward.

What If the Stock Becomes Worthless?

You don’t need to sell your shares to claim a Section 1244 loss. If the corporation fails and the stock becomes completely worthless, the IRS treats it as if you sold the stock on the last day of that tax year. Keep evidence such as bankruptcy filings or financial statements to support the claim.

‍How to Report Section 1244 Losses

Losses under Section 1244 aren’t reported the same way as regular capital losses. If you sell or dispose of qualifying stock at a loss, you use Form 4797 (Sales of Business Property) to report the ordinary portion of the loss. Any amount above the $50,000 (single) or $100,000 (married filing jointly) annual limit is reported as a capital loss on Schedule D and Form 8949.

Because of these dual treatments, it’s important to separate what qualifies as ordinary loss vs. excess capital loss when filing.

Keep Good Records
The IRS requires proof that your stock qualifies under Section 1244. Keep:

The corporation’s formation documents show capitalization below $1M.
Evidence you purchased at the original issue.
Financial statements showing gross receipts from operations.

Without clear records, your claim could be denied during an audit.

This information is for educational purposes only and does not constitute financial advice. Consult a qualified professional before making any investment decisions.

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