Taking stock of losses.

Given the current economic situation, it is important to remember there are still some benefits in the Internal Revenue Code for taxpayers with financial difficulties. Section 1244 is one such benefit.

Section 1244 was enacted in the late 1950s to encourage investment in small businesses and to lessen the inequity in the treatment of the sale of a small corporation's stock versus the sale of an unincorporated business. Under this provision, losses on the sale or exchange of a small corporation's stock (section 1244 stock) may be deducted as ordinary losses rather than as capital losses subject to the capital loss limits.

QUALIFICATIONS

To qualify as section 1244 stock, requirements must be met, both for the corporation and its shareholders, when the stock is originally issued. In addition, the corporation must meet other requirements in the year the loss from the disposition of the stock is taken.

When stock is issued. To be a small business corporation, the total amount of money and property received by the corporation for its stock (as contributions to capital and paid-in capital) cannot exceed $1 million when issued. This determination is made when any stock is originally issued and includes the value of any previously issued stock.

S corporations. S corporations do not automatically qualify as small business corporations for section 1244 purposes.

When loss is sustained. In addition, the corporation must pass a "gross receipts test" in the year the loss is sustained. For the preceding five tax years (or the corporation's life, if less than five years) more than 50% of the aggregate gross receipts must be from noninvestment income (that is, not royalties, rents, dividends, interest, annuities and sales or exchanges of securities). Basically, this requirement means the company must be engaged in an active trade or business.

Qualified consideration. To be section 1244 stock, it must be issued for money or property other than stock or securities. Thus, section 1244 stock can be issued in exchange for the cancellation of indebtedness (not arising from the performance of personal services). However, such an indebtedness must be a bona fide and must not be considered a security. Central to this process is the intent of the parties to create a valid indebtedness. Among the factors used in this determination are

* Whether there are the formal indexes of debt (an unconditional obligation to pay a fixed sum on demand or at maturity, a fixed and unconditional rate of interest, a written obligation, creditors' remedies)

* The conduct of the parties (treatment of the debt on the corporation's and the debt holder's books)

* Whether there is a reasonable expectation of repayment (for example, the corporation's capitalization and creditworthiness or its debt-equity ratio).

ELIGIBLE TAXPAYERS

Section 1244 stock treatment is available only to the individuals (or partnerships) to whom the stock is originally issued. Stock issued to a partnership qualifies in regard to the individual partners. However, stock issued to a partnership and distributed by the partnership to the individual partners before the loss is sustained does not qualify.

Ordinary loss treatment is available only to individuals and partnerships. Corporations, trusts and estates are not eligible.

NOTE: Before November 7, 1978, Section 1244 stock had to be issued pursuant to a written plan and could be offered only during a period that could last up to two years. In addition, section 1244 stock issued before July 18, 1984, had to be common stock. Neither of these restrictions applies to current offerings of section 1244 stock.

LIMITS ON LOSSES

There are also limitations on the losses allowed to section 1244 shareholders each year.

Single individuals are allowed an annual maximum deduction of $50,000 of section 1244 loss ($100,000 for married individuals filing jointly). Losses in excess of these amounts are considered capital losses; a loss in excess of a taxpayer's taxable income for a given year may be treated as a business loss available for net operating loss carryback or carryover and not subject to any section 1244 limitations.

The amount of loss eligible for section 1244 treatment also is limited to the fair market value of the property contributed when the stock is issued. This may be a problem when the stock is issued in exchange for the cancellation of a debt. If the debt was worthless before the exchange, the stock has no value and therefore no amount of loss can be deducted.

For a discussion of this and other developments, see the Tax Clinic, edited by Mitchell Stump, in the December 1990 issue of The Tax Adviser.