Claiming ordinary losses for Sec. 1244 stock.[ILLUSTRATION OMITTED] SEC. 1244 ENCOURAGES NEW INVESTMENT in small business by permitting investors to claim an ordinary (rather than a capital) loss on the disposition (including worthlessness worth·less adj. 1. Lacking worth; of no use or value. 2. Low; despicable. worth  less·ly adv. ) of qualifying small business
stock. As an added benefit, any loss that qualifies as an ordinary loss
under Sec. 1244 is also treated as a trade or business loss in computing computing - computer an individual's net operating loss operating lossThe excess of operating expenses over revenue. As with operating income, operating losses exclude revenues and expenses from operations that are not considered a regular part of the business. Also called deficit. Compare operating income. (NOL NOL - Never Offline ). Thus, Sec. 1244 losses are allowed for NOL purposes without being limited by nonbusiness non·busi·ness adj. 1. Unrelated to business or industry. 2. Unrelated to one's own business or employment. income. An annual limitation is imposed on the amount of Sec. 1244 ordinary loss that is deductible That which may be taken away or subtracted. In taxation, an item that may be subtracted from gross income or adjusted gross income in determining taxable income (e.g., interest expenses, charitable contributions, certain taxes). . The maximum deductible loss is $50,000 per year ($100,000 if a joint return is filed) (See. 1244(b)). Any loss in excess of the limit is a capital loss, subject to the capital loss rules. Thus, if the potential loss exceeds the $50,000 (or $100,000) limit, the stock should be disposed of in more than one year to maximize the ordinary loss treatment. Example 1: In 1998, M contributed $150,000 cash to his corporation, N Co., in exchange for stock. The business never attained the success M originally envisioned. In 2008, M sold his stock This case study has been adapted from PPC's Guide to Tax Planning Tax planning Devising strategies throughout the year in order to minimize tax liability, for example, by choosing a tax filing status that is most beneficial to the taxpayer. for High Income Individuals, 9th Edition, by Anthony J. DeChellis, Patrick L.Young, James D.Van Grevenhof, and Delia D. Groat, published by Thomson Tax & Accounting, Ft.Worth, TX, 2008 ((800) 323-8724; ppc.thomson.com). to an unrelated party for $40,000. M's tax loss on his sale of stock is $110,000 ($40,000 proceeds--$150,000 stock basis). The stock qualified as Sec. 1244 stock. M files a joint return with his wife, L. In the year of sale, M can claim a $100,000 ordinary (Sec. 1244) loss deduction and a $10,000 capital loss. If M has no 2008 capital gains, his capital loss is limited to $3,000 (with the balance carried forward), but his ordinary deduction is allowed in full in 2008, assuming he has adequate taxable income Under the federal tax law, gross income reduced by adjustments and allowable deductions. It is the income against which tax rates are applied to compute an individual or entity's tax liability. The essence of taxable income is the accrual of some gain, profit, or benefit to a taxpayer. . Example 2: Now assume instead that M sells 90% of his N stock in 2008 for $36,000 and the remaining 10% in early 2009 for $4,000. M's tax loss on his 2008 stock sale is $99,000 [$36,000 proceeds--($150,000 stock basis x 90%)]. M's tax loss on his 2009 stock sale is $11,000 [$4,000 proceeds --($150,000--$135,000)]. By structuring the sale of stock over two years, M is able to avoid the $100,000 annual limitation on Sec. 1244 losses. Therefore, M can claim a $110,000 ($99,000 in 2008 + $11,000 in 2009) ordinary (Sec. 1244) loss deduction and avoid a capital loss on the stock sale. Practitioners should attempt to structure a corporation so that the stock qualifies for Sec. 1244 treatment. No election is necessary. There is no penalty for failing to qualify stock for Sec. 1244 treatment. The only result of failure is that the stock is treated the same as it would be if no attempt had been made. In many cases, no special planning is needed. Many small corporations will qualify for Sec. 1244 treatment because of the nature and size of their business. Practitioners should also be alert for sales of stock that may qualify for Sec. 1244 loss treatment. This is particularly true for sales of closely held A phrase used to describe the ownership, management, and operation of a corporation by a small group of people. In a closely held corporation, the same people often act as shareholders, directors, and officers, and no outside investors exist. or other nonpublicly traded stock. Meeting the Sac. 1244 Requirements For stock to be considered Sec. 1244 stock, the following requirements must be met as of the date of issuance. First, the corporation must be a small business corporation. A domestic corporation (including an S corporation) is a small business corporation if, when the stock is issued, the total amount of money and property received by the corporation for stock (or as a contribution to capital or as paid in surplus) does not exceed $1 million (Secs. 1244(c)(1)(A) and (3)(A)). This determination is made each time stock is issued and includes the amount received by the corporation when issuing that specific stock. In the year the $1 million threshold is exceeded, the corporation may designate des·ig·nate tr.v. des·ig·nat·ed, des·ig·nat·ing, des·ig·nates 1. To indicate or specify; point out. 2. To give a name or title to; characterize. 3. the shares to be treated as Sec. 1244 stock. If the corporation does not make a designation, the remaining Sec. 1244 benefit is allocated among all shares issued that year (Regs. Sec. 1.1244(c)-2(b)). Observation: For contributions of property other than money, the amount considered when computing a Sec. 1244 loss is the property's adjusted basis reduced by liabilities to which the property is subject or that the corporation assumed. However, if the property's fair market value (FMV FMV - full-motion video ) is less than its adjusted basis when it is transferred to the corporation, any Sec. 1244 (ordinary) loss is limited to the property's FMV at that transfer date (Sec. 1244(d)(1)(A); Regs. Sec. 1.1244(d)-1). Second, the stock must be issued in exchange for cash or other property (other than stock and securities) (Sec. 1244(c) (1)(B)). Thus, stock issued in exchange for services does-not qualify (Regs. Sec. 1.1244(c)-1(d)(1)). (If possible, the corporation should pay shareholders in cash for services rendered and then permit them to buy the stock, if desired.) Stock issued in exchange for stock or securities, including stock of the issuing corporation, normally does not qualify for Sec. 1244 treatment. However, stock received in (1) certain stock dividend transactions, (2) an E reorganization (a recapitalization Recapitalization Restructuring a company's debt and equity mixture often with the aim of making a company's capital structure more stable. Notes: Companies often want to diversify their debt-to-equity ratio to improve liquidity. ) under Sec. 368(a)(1)(E), or (3) an F reorganization (a change in identity, form, or place of organization) under Sec. 368(a) (1)(F) can qualify. Cancellation of a bona fide [Latin, In good faith.] Honest; genuine; actual; authentic; acting without the intention of defrauding. A bona fide purchaser is one who purchases property for a valuable consideration that is inducement for entering into a contract and without suspicion of being debt in exchange for stock qualifies for Sec. 1244 treatment, unless the debt is evidenced by a security or arises out of the performance of personal services personal services n. in contract law, the talents of a person which are unusual, special or unique and cannot be performed exactly the same by another. These can include the talents of an artist, an actor, a writer, or professional services. (Regs. Sec. 1.1244(c)-1(d)(1)). However, stock exchanged for debt that is worthless when exchanged will not generate a Sec. 1244 loss because the basis of the stock will be zero. To prevent this, debt should be converted into stock as early in the corporation's life as possible. Waiting to convert until the company reaches a hardship stage (i.e., insolvency insolvency Condition in which liabilities exceed assets so that creditors cannot be paid. It is a financial condition that often precedes bankruptcy. In the context of equity, insolvency is the inability to pay debts as they become due; insolvency under the balance-sheet ) increases the odds that a Sec. 1244 loss will be disallowed. Third, the stock must be issued directly to the original owner, who is the only one entitled en·ti·tle tr.v. en·ti·tled, en·ti·tling, en·ti·tles 1. To give a name or title to. 2. To furnish with a right or claim to something: to claim a Sec. 1244 loss (Regs. Sec. 1.1244(a)-1(b)). In addition, the owner must be an individual or a partnership (Sec. 1244(a)). In the case of a Sec. 1244 loss passed through a partnership, the loss is deductible only by individuals who were partners both when the stock was issued to the partnership and when the loss is sustained (and then only to the extent that their partnership interest has not decreased since the stock was purchased by the partnership). Any Sec. 1244 stock held by a partnership and subsequently distributed to partners is not Sec. 1244 stock in the partners' hands (Regs. Sec. 1.1244(a)-1(c)). Finally, the stock can be either common or preferred, provided the preferred stock Stock shares that have preferential rights to dividends or to amounts distributable on liquidation, or to both, ahead of common shareholders. Preferred stock is given preference over common stock. Holders of preferred stock receive dividends at a fixed annual rate. was issued after July 18, 1984 (H.R. Rep't No. 98-432, 98th Cong., 2d Sess. 1581 (1984)). Common stock does not include securities convertible into common stock or common stock convertible into other securities (Regs. Sec. 1.1244(c)-1(b)). For common stock issued before November 7, 1978, Other requirements must be met. (See Regs. Sec. 1.1244(c)-1(f).) A taxpayer who purchases an existing corporation's stock is not entitled to Sec. 1244 treatment since he or she is not the original owner of the stock. In this situation, taxpayers can avail themselves of Sec. 1244 treatment by purchasing the corporation's assets and transferring them to a new corporation. Meeting the Gross Receipts the total of the receipts, before they are diminished by any deduction, as for expenses; - distinguished from net profits. - Bouvier. See under Gross, a. os> See also: Gross Receipt Test For stock to be considered Sec. 1244 stock in the year the shareholder realizes the loss, the corporation must meet a gross receipts test (Sec. 1244(c)(1)(C)). Under this test, during the five most recent tax years ending before the date the loss was sustained by the shareholder (or the life of the corporation, if less than five years), 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. However, the gross receipts test does not apply if the corporation's cumulative deductions (excluding the NOL carryover carryover n. in taxation accounting, using a tax year's deductions, business losses or credits to apply to the following year's tax return to reduce the tax liability. (See: carryback) and carryback deduction and the special dividends-received deductions Dividends-received deduction A corporate tax deduction on income allowed by company A that is in ownership of shares of company B and receives dividends on the shares of company B. ) exceed its cumulative gross income during the five-year testing period (Sec. 1244(c)(2)(C)). Even if the gross receipts test is passed (or the corporation qualifies for the exception noted in the previous paragraph), the stock will qualify as Sec. 1244 stock only if the corporation is an operating company operating company A business that engages in transactions with outsiders. for the five-year testing period (Regs. Sec. 1.1244(c)-1(e)(2)). It must not be a holding or investment company (e.g., a corporation that acquires and holds nonincome-producing real estate). Editor Notes Albert Ellentuck is of counsel with King & Nordlinger, L.L.A, in Arlington, VA. Editor: Albert Ellentuck, Esq. |
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