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Qualifying for section 1244.

To encourage investment in small businesses, Congress in the late 1950s allowed individual shareholders to deduct losses on the sale, exchange or worthlessness of certain small business corporations' stock. Losses from the disposition of such stock are considered ordinary losses attributable to the shareholder's business, rather than subject to the capital loss limitations.


To qualify as small business corporations, companies cannot have more than $1 million in capital at the time stock is issued; the total amount of money and property received (including the value of any previously issued stock) cannot exceed this amount when the stock originally is issued.

In addition, corporations must meet a passive income test in the year a loss is sustained: The aggregate of any gross receipts generated over the previous five years (or the corporation's life, if less than five years) from rents, royalties, dividends, interest, annuities and sales or exchanges of securities must be less than half of total gross receipts taken in by the corporation in the five-year period.


Generally, section 1244 stock must be issued for money or other property (other than stock or securities). Stock issued to cancel indebtedness may qualify; however, such indebtedness must be bona fide and not be considered a security. In addition, the debt cannot arise from the performance of personal services.


Section 1244 treatment is available only for stock owned by individuals or owned through a partnership; corporations, trusts or estates are not eligible. However, stock issued to partnerships for distribution to the individual partners before the loss is sustained does not qualify.

In addition, section 1244 treatment is available only to the individuals (or partnerships) to whom the stock originally was issued. Thus, persons receiving such stock through purchases, gifts or any other transfers are not eligible to claim ordinary loss treatment.


Corporate records. Corporations that issue section 1244 stock should keep certain records to help shareholders substantiate their ordinary loss deductions. These records should include

* The persons to whom stock was issued, the date of issuance and a description of the amount and type of consideration received from each.

* If the consideration received was property, its basis in the shareholder's hands and its fair market value when received by the corporation.

* The amount of money and the basis in the corporation's hands of other property received in exchange for its stock, as a contribution to capital and as paid-in surplus.

* Corporate financial statements (such as income tax returns) that identify the source of the corporation's gross receipts for the appropriate five-year (or less) period.

Taxpayer records. Taxpayers claiming section 1244 ordinary loss deductions should include with their returns a statement setting forth

* The address of the corporation that issued the stock.

* The manner in which the stock was acquired by the taxpayer and the nature and amount of the consideration paid.

* If the stock was acquired in a nontaxable transaction for property other than money, the type of property, its fair market value on the date of transfer to the corporation and its adjusted basis at that time.

Caution: While the taxpayer record requirements do not seem substantive in nature, the Tax Court held that anything short of complete compliance bars an ordinary loss deduction. Rather than allowing "substantial compliance" with the requirement, the Tax Court ruled that failure to include the appropriate information with a return totally precludes section 1244 treatment. With this in mind, practitioners who prepare returns that include section 1244 stock. losses should take special care to ensure that the necessary information is included.

For a discussion of this and other developments, see the Tax Clinic, edited by William Herrick and Robert Cohen, in the December 1993 issue of The Tax Adviser.

Ed. note: The material discussed provides general information. Before you take any action in this area, the appropriate code sections, regulations, cases and rulings should be examined.
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Title Annotation:from the Tax Advisor
Author:Fiore, Nicholas
Publication:Journal of Accountancy
Date:Dec 1, 1993
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