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Take cover with section 1244.

Take Cover With Section 1244

During this period of economic turbulence, many practitioners have had to handle situations where corporate clients have discontinued operations, disposed of losing businesses or have been forced into a bankruptcy. As a result, we have been faced with the unpleasant duty of advising and assisting our clients regarding the tax consequences resulting from these negative events.

Section 1244 of the Internal Revenue Code, remains a viable relief provision, untouched by the loophole closing efforts of the '86 Tax Reform Act. Sec. 1244, originally enacted in 1958 and amended in 1978, is intended to soften the blow of the losses realized on the sale or worthlessness of stock if certain requirements are met. The following is a discussion of the requirements of the section and some planning strategies for the tax advisor.

Section 1244 Losses in Brief

If Sec. 1244 applies, an individual may take an ordinary loss deduction for a loss sustained on "Sec. 1244 Stock" that would otherwise be a capital loss, (assuming the stock was a capital asset in the hands of the shareholder) thus bypassing the capital loss limitations. The amount of loss that may be deducted as ordinary in the same year is $50,000 for a separate return and $100,000 for a joint return. Any excess will be treated as a capital loss to be applied against capital gains. The requirements of Sec. 1244 are rather specific, but less onerous than prior to amendment of 1978, which removed the requirement that a formal written plan be adopted at corporate inception in order for shares to be considered "Sec. 1244 Stock." However, the tax advisor should have in mind that the following requirements are generally rigidly enforced by IRS and the tax court as case history indicates.

Eligible Shareholders

An ordinary loss on Sec. 1244 stock is available only to individuals. Sec. 1244 does not apply to losses sustained by corporate shareholders or for shares owned by trusts and estates. In addition, ordinary loss treatment is available only to the original investor who acquired their shares from the issuing corporation in exchange for cash and/or property. Therefore, a subsequent transfer to a second party will remove the stock from Sec. 1244 consideration. Transfer is deemed to be any conveyance including sale, gift, inheritance, etc. The accountant should be aware that only shares acquired directly from the issuing corporation will be considered Sec. 1244 stock. The original shareholder must have received stock in exchange for cash and/or property. Per Sec. 1244 property does not include stock and securities. However, Reg. 1.1244(d)(3) provides for three exceptions which lessen the impact of this restriction:

1. Receipt of a stock dividend. 2. Receipt of stock as part of a

reorganization under Sec. 368

(a)(1)(E). 3. Receipt of stock as part of a

reorganization under Sec. 368


Generally, most original incorporating shareholders will meet the cash/property requirement as either solely cash to be contributed or as an ongoing business incorporated in exchange for stock.

Partners of a Partnership

Individuals who are partners in a partnership which sustains a loss on Sec. 1244 stock may be allowed an ordinary deduction. The individual partners will report an ordinary loss to the extent of their distributive share of partnership income and loss.

Example: A and B, individuals, and C, a corporation, are equal partners in a partnership owning Sec. 1244 stock. The partnership sells that stock for a $60,000 loss. A and B may each take an ordinary loss of $20,000 each (1/3 each). However, partner C, which is a corporation, is not eligible for Sec. 1244 treatment, and therefore is restricted to capital loss limitations.

In order for the individual partner to obtain an ordinary loss he/she must have been a partner at the time the partnership received the stock and continuously thereafter until disposal creating the Sec. 1244 loss.

In addition, ordinary loss will be denied in situations where the partnership transfers shares to a partner who then sells the shares at a loss. The partners are not deemed to have received the shares from the original issuing corporation (Prizant v. Commissioner T.C. Memo 1971-196.30 TCM 817 1971).

"Section 1244 Stock" Defined

In order for stock to qualify as "1244 Stock" and thus be eligible for ordinary loss treatment, the following requirements must be met:

1. The stock must be issued by a

domestic corporation. 2. The stock must be issued for

money or property, other than

stock or securities. 3. The corporation was a "small

business corporation" as defined

in Sec. 1244(c)(3) at the time the

shares were issued. 4. For the previous five taxable

years, the corporation derived

more than 50% of its aggregate

gross receipts from sources other

than royalties, rents, dividends,

interest annuities and sales of

stock and securities. (See Table


Small Business Corporation

The term "small business corporation" as applied to Sec. 1244, should not be confused with the term as it applies to Sub Chapter S corporations. A corporation may meet the small business requirement of Sub Chapter S, yet fail to meet the requirements for Sec. 1244. However, many corporations can meet both requirements and obtain the benefits of both sections.

A corporation qualifies as a "small business corporation" under Sec. 1244 if, at the time the stock was issued, the cash and property received by the issuing corporation as a contribution of capital and paid-in surplus does not exceed $1 million. The $1 million limitation is determined at the time the stock is issued and includes all previous issuances. If capital is contributed which brings the total contributed capital above the $1 million limitation, the corporation must designate which shares will be considered Sec. 1244 stock. Therefore, a "small business corporation" may have total contributed capital well in excess of $1 million. However, only the first $1 million worth of shares may carry the Sec. 1244 designation.

Example: X corporation is incorporated on July 1, 1982 and issues 100 shares to shareholder A for $500,000 and 50 shares to shareholder B for $250,000. Thus, at the end of 1982 total capital is $750,000. Therefore no designation of shares is required at this time. In 1983, shareholder C contributes $500,000 for 100 shares. Since the contribution of $500,000 brings the total capital to $1,250,000, the corporation must designate which 50 share ($250,000 worth of stock) will be Sec. 1244 stock and the remaining 50 shares will not qualify for Sec. 1244 treatment. Any additional shares issued will not qualify for Sec. 1244 loss.

As can be seen, for all purposes, it is the initial $1 million of capital stock issued which will qualify as Sec. 1244 stock. The one million limitation was not intended to limit the size or total capital of a corporation. If non-cash property is contributed in exchange for stock, the property is taken into account at its adjusted basis to the corporation at the time of the contribution less any liabilities assumed by the corporation.

Example: Z corporation receives property with a fair market value (FMV) of $800,000, adjusted bases of $400,000 and assumes a $100,000 liability on the property. The transaction qualifies under Section 351 and therefore, the carryover basis is $400,000. Since the net capital contributed is $300,000 (adjusted basis $400,000 - 100,000 liability), the corporation could issue an additional $700,000 ($1 million limitation - $300,000) worth of stock which could qualify as Sec. 1244 stock.

Stock Issued for Property

As discussed previously, the stock must be issued for cash and/or property, with some specific exceptions (stock dividend, certain reorganizations). Some issues could arise in this area which would disqualify stock for Sec. 1244.

For example, stock issued for services will not be treated as Sec. 1244 stock since services are not considered property. In addition, in order to qualify for Sec. 1244, actual shares must be issued for the property. Therefore, the number of outstanding shares must increase. Frequently, especially in the case of closely held corporations, contributions to capital are made by the shareholder(s) without an issuance of shares. This will produce a basis increase, however, the additional capital contributed will not qualify for ordinary loss treatment.

Example: Shareholder A owns 100% (100 shares) of the stock of Y corporation. The basis of the stock in the hands of A is $10,000. The stock qualifies as Sec. 1244 stock. In 1988, due to adverse business performance, A contributes an additional $30,000 into Y without taking additional shares. A's total basis in Y shares is now $40,000. On worthlessness of Y shares the initial $10,000 investment will qualify for Sec. 1244 ordinary loss treatment. The loss on the $30,000 investment, since no additional shares were issued, will be subject to capital loss rules. This position has been rigidly enforced by the Internal Revenue Service and the Tax Court.

In a recent case, Pierce v. Commissioner TC Memo 1989-647, this issue was again reviewed and Sec. 1244 treatment denied to subsequent capital contributions where no new shares were issued. In the aforementioned case, Pierce, an individual, invested $800 when he organized Obelus, Inc. Stock was issued in exchange for the shares at that time.

In addition, Pierce acquired $200 worth of stock from other shareholders. Subsequently, Pierce invested $80,000 originally as a loan, which the court converted to a capital investment. Pierce was denied ordinary loss treatment for the additional investment. The court cited Sec. 1244(d)(1)B and characterized the loss attributable to the additional investment as a capital loss. The loss attributable to the original issuance was allowed as ordinary under Sec. 1244.

Clearly, this decision reinforces the regulatory requirement that shareholders receive stock in exchange for property contributed. Proper tax planning requires that any additional capital contributions be evidenced by new shares issued, even in the case of sole shareholders where additional share issuance would appear to be meaningless.

Gross Receipts Test

In order for stock to qualify under Section 1244, the corporation must derive more than 50% of its aggregate gross receipts from sources other than rents, royalties, dividends, interest, annuities and sales or exchanges of property. The 50% rule applies to the aggregate gross receipts for the corporation's five most recent taxable years ending before the date of the loss.

If the corporation has not been in existence for five years, the test is applied for all of the years the corporation has been in existence. Keep in mind that the 50% test applies to aggregate gross receipts for the 5-year period. Therefore, the corporation can fail the test in any particular year, yet be able to meet the 50% requirement for the entire period (See Table 1).

The purpose of the test is to limit Sec. 1244 treatment to operating companies. The writers of the law wished to prevent investment type activities, whose losses were generally subject to capital gain limitations, from receiving more favorable ordinary loss treatment.

Under the regulations, gross receipts is defined as the "total received or accrued" under the method of accounting used by the corporations. It is not synonymous with gross income. Therefore, it is not reduced by sales returns, costs of goods sold or deductions.

Loss Calculations and Limitations

Section 1244 imposes an annual limitation on the amount of loss which can be taken as ordinary on sale or worthlessness of Sec. 1244 stock. The ordinary loss may not exceed $50,000 for individuals (and married filed separately) and $100,000 for married taxpayers filing jointly. Any loss in excess of the limitations is to be treated as a capital loss. In the case of partnership holdings of Section 1244, the limitations are calculated on each partner's return not at the partnership level. It does not matter when the shares where issued and the limitation is calculated per shareholder not per corporate loss.

Example: During 1989 unmarried individual A sustained a loss of $20,000 on stock X, acquired in 1983 as qualifying Sec. 1244 stock. In the same year, A sustained a $40,000 loss on stock Y issued in 1984 as qualified Sec. 1244 stock. A would be allowed an ordinary loss of $50,000 ($20,000 + $40,000 subject to $50,000 limitations) on his/her 1989 return. The $10,000 excess is treated as a capital loss.

The limitation imposed by Sec. 1244 is an annual, not life time limitation. Therefore, taxpayers may claim Sec. 1244 loss in any number of years on any number of Sec. 1244 stock issues, subject to annual limitations and other requirements of Sec. 1244.

Example: If individual A, from our previous example, sold the Sec. 1244 shares of stock Y ($40,000 loss) in 1990 instead of 1989, an ordinary loss on stock X ($20,000) would have been allowed in 1989, as well as an ordinary loss in 1990 for the full $40,000 loss of stock Y as the taxpayer has not exceeded the $50,000 limitation either year.

The tax advisor should work closely with clients who have multiple corporate interests to effectively plan disposal and/or liquidation in order to avoid "bunching" of losses in single years.

If the ordinary loss sustained by a shareholder exceeds his/her's taxable income, a net operating loss is created and the NOL is treated as a loss attributable to trade or business activities. The excess may be carried back or forward as an NOL not as a Sec. 1244 loss. Therefore, if the shareholder sustains another Sec. 1244 loss in a carryforward year, the NOL is not added to that loss for limitation purposes.

Section 1244 and Sub Chapter S Corporations

Section 1244 loss treatment can be utilized for shares issued by Sub Chapter S corporations. In this situation, the shareholder can utilize the annual operating losses of the S corporation, as well as taking an ordinary loss for the loss on sale or worthlessness of the S stock. Keep in mind that the basis of S corporation shares must be reduced by any operating losses utilized prior to disposal. The requirements of Sub Chapter S and Sec. 1244 operate independently, thus the requirements of both sections must be met for shares of S corporations to be considered Sec. 1244 stock.

Example: Individual A forms XYZ Corporation in 1985, by investing $150,000 for the shares. The shares qualifies for Sec. 1244 treatment. XYZ Corporation properly elects Sub S status beginning in 1985. From 1985 to 1990, XYZ sustains operating losses of $120,000 which are passed through to A and utilized in the personal return. Thus, A's basis in XYZ stock is reduced to $30,000. Assume all other requirements of [Subsection] Sec. 1244 are met (gross receipts, small business, etc.), A may take an ordinary loss of $30,000 as a Sec. 1244 loss on the worthlessness of XYZ shares.

Procedural Requirements

The regulations require that any taxpayer claiming an ordinary loss on Section 1244 stock include the following with their tax returns:

a. Address of corporation

assuming the stock b. Manner in which stock was

acquired c. If stock was acquired in a non

taxable exchange for property,

the type of property, FMV on

date of transfer and adjusted

basis on such date.

In addition, both the shareholder and issuing corporation should maintain records which designate Sec. 1244 stock from non-Sec. 1244 stock if both exist.


Section 1244 remains a viable method for a shareholder to utilize ordinary loss treatment on sale or worthlessness of corporate stock. The requirements are specific and are rigidly enforced. The tax planner should take proper care to review the following to ensure Sec. 1244 application:

1. Sec. 1244 ordinary loss will only

be available to the original

individual shareholders. Subsequent

transfers will remove the shares

from Sec. 1244 consideration. 2. Sec. 1244 shares can only be

acquired in exchange for cash

and/or property. 3. The corporation issuing the stock

must be an operating company

(gross receipts test). 4. Only the first $1 million of

capital shares can be treated as [Subsection] Sec.

1244 stock (small business

corporation). 5. Any additional capital

contributions should be evidence by new

shares, even for sole shareholders

(Pierce case). 6. Sec. 1244 can be utilized in

conjunction with Sub Chapter S

corporation. However, a valid S

election does not automatically

make shares Sec. 1244 stock.

Conditions of Sec. 1244 must

also be met.

Table 1

Loss taken on 3/1/90. (Calendar Year Corporation)

Gross Receipts
 1985 1986 1987 1988 1989 Total
Rents 800 800 900 1000 1000 4500
Interest 100 100 100 100 100 500

Receipts 700 800 1500 2000 2500 7500
 Total Receipts For 5-year Period 12500
 Total Operating Receipts 7500

Since more than 50% of receipts for period derived from operating activities,

James B. Rosa, CPA, MBA, is an assistant professor of accounting at Queensborough Community College of the City University of New York. Prior to joining Queensborough, he was employed at the Internal Revenue Service as a revenue agent training manager. He is a member of the AICPA and the New York State Society of CPAs.
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Title Annotation:includes related article; Internal Revenue Code
Author:Rosa, James B.
Publication:The National Public Accountant
Date:Jan 1, 1992
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