Allocating allowable sec. 1244 loss among shareholders when total capital exceeds $1 million.

Facts: On june 1, 1979, newly formed ABC Corporation authorized 600,000 shares of common stock to be issued with a $1 par value. On june 5, 1979, 300,000 shares were issued at par to Alan and 300,000 shares were issued at par to Bill. On June 30, 1981, ABC authorized the issuance of another 600,000 shares of common stock on July 1, 1981. Of these additional 600,000 shares, 100,000 were issued to Alan, 100,000 to Bill and 400,000 to a new shareholder, Connie. All stock was issued in exchange for cash. ABC was always actively engaged in the manufacturing industry. It was fairly successful the first few years, but as the local economy worsened it began incurring large losses. On Jan. 31, 1996, ABC was forced into bankruptcy. The stock was declared worthless in 1996. 9 Both Alan and Bill are married and file joint returns. Connie is single. Taxable income for the three for 1996 before application of the Sec. 1244 loss is as follows: Alan, $175,000; Bill, $156,000; and Connie, $78,000. None of the three have any capital gains in 1996. Issue: What portion of each shareholder's stock loss can be treated as an ordinary loss?

Analysis

The original issuance of ABC's stock on june 5, 1979, in the amount of $600,000, qualifies as Sec. 1244 stock. 1. The total amount contributed to capital and paid-in surplus at that time was $1 million or less. 2. The stock was common stock originally issued to qualified shareholders in exchange for cash. 3. Because ABC was actively involved in the manufacturing business, it is reasonable to assume that the gross receipts test would be met.

However, the issuance of $600,000 of additional stock on July 1, 1981 brought ABC's total capital to $1.2 million. At that point, the small business corporation limitation of $1 million was exceeded. The excess will not qualify as Sec. 1244 stock and will be subject to capital loss treatment. The year 1981 is the "transitional year" because the issuance of stock exceeded the $1 million limitation in that year. Any stock issued after that date will not qualify as Sec. 1244 stock.

A corporation may designate which shares issued in the transitional year are Sec. 1244 shares. In the absence of a proper designation by the corporation, the following formula is used to compute the Sec. 1244 loss permitted on any individual's disposition of the stock:

[MATHEMATICAL EXPRESSION OMITTED]

Assuming ABC did not make a Sec. 1244 designation on the issuance of stock in 1981, the shareholders must compute their losses in regard to this stock as follows:

Sec. 1244 deduction for Alan and

Bill:

($1,000,000 - $600,000) / 600,000

x $100,000 = $66,667 each

Sec. 1244 deduction for Connie:

($1,000,000 - $600,000) / $600,000

x $400,000 = $266,666

Therefore, Alan and Bill each have a Sec. 1244 loss of $366,667 ($300,000 loss from original issuance + $66,667 as computed). Connie's Sec. 1244 loss is $266,666. The total loss of $1.2 million is initially allocated as follows:

         Sec. 1244 loss    Capital      Total
          (ordinary)        loss        loss

Alan     $  366,667       $ 33,333   $  400,000
Bill        366,667         33,333      400,000
Connie      266,666        133,334      400,000

         $1,000,000       $200,000   $1,200,000

Even though $1 million of the stock qualities as Sec. 1244 stock, the shareholders cannot deduct ordinary losses of $1 million. There are two limitations on the amount of Sec. 1244 loss allowed to shareholders in a year: 1. A single taxpayer is limited to a deduction of $50,000 in any tax year; a married taxpayer filing a joint return may deduct $100,000 in any tax year. In this case study, all individuals' Sec. 1244 losses will be limited because their losses exceed these limitations. The excess becomes a capital loss and is subject to capital loss limitation rules. 2. The Sec. 1244 loss is then limited to the amount of taxable income before considering the loss. Due to these limitations, the shareholders' losses are as follows:

           Sec. 1244
           maximum          Capital      Total
         loss (ordinary)     loss        loss

Alan        $100,000(*)    $300,000   $  400,000
Bill         100,000(*)     300,000      400,000
Connie        50,000(*)     350,000      400,000

            $250,000       $950,000   $1,200,000

(*) The taxable income limit does not apply
because all three taxpayers have income in
excess of their allowed ordinary losses.

Any portion of the loss considered ordinary because of the application of Sec. 1244 (i.e., the maximum Sec. 1244 ordinary loss of $100,000 for married taxpayers and $50,000 for single taxpayers) will be treated as pertaining to the taxpayer's trade or business for determining the net operating loss (NOL) deduction available for carryover under Sec. 172. Therefore, if a taxpayer does not have sufficient income to offset the allowed ordinary portion of the loss in a tax year, the excess may be carried to another year as part of an NOL.

Conclusion

Because all Sec. 1244 requirements were met both on the original issuance of the stock and at the date the loss occurred, $1 million of the stock qualifies as Sec. 1244 stock and some part of the loss win be ordinary. However, because of the limitation on the maximum ordinary loss in any tax year, the shareholders cannot claim ordinary losses totaling $1 million (i.e., Alan and Bill cannot claim an ordinary loss in 1996 for the full $366,667 each, nor can Connie for her $266,666). The actual treatment on their 1996 income tax returns, since none of the three has any additional capital gains or losses, is shown below.

Variation

Assume the three shareholders sold some of their Sec. 1244 stock in 1995 before the corporation declared bankruptcy in 1996. In that case, they would be entitled to ordinary losses on the stock they sold in 1995 and on the worthless stock in 1996 (because the $100,000/$50,000 limitation applies on an annual basis). The limitations may apply to Sec. 1244 stock of the same corporation in several different years.

[TABULAR DATA OMITTED

Editor's note: This case study has been adapted from "PPC Tax Planning Guide - Closely Held Corporations," 8th Edition, by Albert L. Grasso, R. Barry Johnson, Linda Ketter, Lewis A. Siegel, Joan Wilson Gray, Elizabeth DiTommaso and James D. Eversole, published by Practitioners Publishing Company, Fort Worth Tex., 1995.