8762 / What special rules apply to the deductibility of losses incurred on small business stock?

Generally, shareholders will realize either a capital gain or loss upon the sale or disposition of stock (see Q 8761). However, the taxpayer treats the loss as an ordinary loss if it results from the disposition of certain small business stock under IRC Section 1244.¹ The loss could either arise from the sale of the small business stock, or from a determination that the stock is worthless. This ordinary loss treatment is applicable for both common and preferred stock.

Even though an individual may be entitled to ordinary loss treatment upon the sale of
Section 1244 stock, the section does not apply to gains. Therefore, if a taxpayer realizes gain on the sale of Section 1244 stock, the gain is treated as a capital gain.

In a taxable year, the maximum amount of ordinary loss that can be claimed by a taxpayer under these provisions is $50,000 (or $100,000 for a married couple filing a joint tax return).² Any excess is treated as capital loss (see Q 8633 for a detailed explanation of the treatment of capital losses).

Stock in a domestic corporation is considered Section 1244 stock if the following requirements are met:³

(1)  at the time the stock is issued, the corporation was a small business corporation (defined below);

(2)  the stock was issued by the corporation in exchange for money or other property (excluding other stock and securities); and

(3)  the corporation, during its five most recent tax years ending before the date the loss was sustained, derived more than 50 percent of its aggregate gross receipts from sources other than royalties, rents, dividends, interest, annuities, and sales or exchanges of stock or securities.⁴

A corporation qualifies as a small business corporation if the amount received by the corporation for stock does not exceed $1 million.⁵

Ordinary loss treatment is permissible if (1) the taxpayer was the shareholder to whom the stock of the small business corporation was issued and (2) the taxpayers are individual taxpayers who are partners in a partnership at the time the partnership acquired stocks in a small business corporation. ⁶

Corporations (including S Corporations), trusts, and estates are not entitled to ordinary loss treatment under Section 1244 regardless of how the stock was acquired.⁷ Individual taxpayers, other than the original holders of the stock, are also not entitled to ordinary loss treatment under Section 1244.⁸ Stock is considered to have been issued once it has been fully paid for by the shareholder whether or not a certificate is prepared and delivered to the stockholder. ⁹

Small business corporations should maintain adequate records to support any shareholder claims for ordinary loss treatment. The records should be sufficient to show:¹⁰

(1)  the persons to whom stock was issued, the date of issuance to these persons, and a description of the amount and type of consideration received from each;

(2)  If the consideration received is property, the basis in the hands of the shareholder and the fair market value of the property when received by the corporation;

(3)  The amount of money and the basis in the hands of the corporation of other property received for its stock, as a contribution to capital, and as paid-in surplus;

(4)  Financial statements of the corporation, such as its income tax returns, that identify
the source of the gross receipts of the corporation for the period consisting of the five most recent taxable years of the corporation, or, if the corporation has not been in existence for five taxable years, for the period of the corporation’s existence; and

(5)  Information relating to any tax-free stock dividend made with respect to Section 1244 stock and any reorganization in which stock is transferred by the corporation in exchange for Section 1244 stock.

In addition, a person who owns Section 1244 stock in a corporation must maintain records sufficient to distinguish such stock from any other stock he or she may own in the corporation.¹¹