The Internal Revenue Code tactfully provides US taxpayers with specific forms of relief that are offered through various stipulations found within the code itself. One of these stipulations is section 1244, which allows individuals and partnerships to treat the losses sustained on the sale of small business stock as ordinary rather than capital losses.
The difference between ordinary and capital losses is significant. Capital losses are subjected to an annual $3,000 deduction limit and ordinary losses are free of any such restriction on a maximum annual deduction, thereby offering the small business shareholder a greater form of tax relief in the year that the loss on the stock was sustained.
There are a few requirements specified in section 1244 that must be met by:
1) the shareholders, and
2) the stock issued by the small business corporation and,
3) the small business corporation itself.
So, how does the IRS define a “small business corporation”?
According to section 1244, a corporation will fall under the classification of a small business corporation if they do not exceed $1,000,000 in capital. Otherwise, the stock issued when a corporation surpasses this threshold will no longer qualify as section 1244 stock, and the shareholders of the corporation will not be able to treat a loss on the stock as ordinary.
The section prescribes that the corporation must have generated more than 50% of its revenue from its trade or business as opposed to passive income items such as rents, royalties, dividends, interest, or annuities.
In order for the stock of the small business corporation itself to qualify, it must have been issued in exchange for money and/or property. This exchange strictly prevents services rendered by the corporation issuing the stock. The stock should also not be convertible into other form of securities (such as a preferred convertible stock), and, if it is common stock, it must have been issued prior to July 19, 1984 to meet the guidelines outlined in section 1244.
According to section 1244, partnerships are eligible to claim the advantageous treatment of the loss on the sale or exchange of a capital asset as an ordinary rather than a capital loss. Section 1244 precludes corporations, trusts, and estates from treating losses sustained on small business corporation stock as ordinary.
As long as the individual or partner in the partnership does not incur ordinary losses in excess of $50,000 or $100,000 if married filing jointly, an ordinary loss from the sale or exchange of a capital asset is fully deductible in the year incurred.
If the loss is greater than $50,000 or $100,000 for a joint return, the excess should be treated as a capital loss.
Section 1244 offers a substantial amount of tax relief for those individuals and partners in a partnership who have sustained losses – allowing these losses to be treated as ordinary.
Get in touch with Paragon Accountants today to find out if you are eligible for an ordinary loss deduction on your small business corporation stock!
