Allocating allowable sec. 1244 loss among shareholders when total capital exceeds $1 million.
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
($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.
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.
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.
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|Author:||Ellentuck, Albert B.|
|Publication:||The Tax Adviser|
|Date:||Jan 1, 1996|
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