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Losses on the Sale of Small Business Stock (Section 1244)

According to statistics published by the American Bankruptcy Institute, there were an average of 59,765 business bankruptcies per year in the United States between 1980 and 2000.

As a result, a lot of people have lost most, if not all, of their invested capital. Under the tax code, you are only allowed to deduct $3,000 of net capital losses each year. But there is an exception to these rules under Internal Revenue code section 1244. This section offers relief to individuals who suffer capital losses when they sell stock of a qualifying small business.

Under section 1244, losses that would otherwise be treated as capital losses are treated as ordinary losses. This has several advantages to the individual:

  • Ordinary losses are not limited to $3,000 per year. Your ordinary losses can be fully deducted in the year of the loss.
  • Ordinary losses are not netted with capital gains that are subject to a maximum tax rate of 20%. Therefore, if you have capital gains in the same year you have ordinary losses, you can still enjoy the capital gains rates.
  • Ordinary losses offset other sources of income that is taxed at ordinary rates, which can be as high as 35% in 2003.

The maximum 1244 loss that can be taken in any year is:

  • $100,000 for married individuals filing a joint return;
  • $50,000 for all others.

To qualify as a section 1244 small business stock there are several requirements that must be met.

  • The stock must come from a domestic corporation. Only stock (including preferred stock) of a domestic corporation can qualify as section 1244 stock. If the stock was issued prior to July 19, 1994, the stock must be common stock.
  • The company must be small. Capital receipts of the company can't be over $1,000,000, including the value of any stock previously issued. If the capital received exceeds $1 million, the corporation must designate which shares are considered 1244 stocks. If, in the year of issue, the capital received goes over the $1 million mark, and the company fails to designate the stock within the required time period, the IRS regulations specify how to allocate the loss between 1244 stock and non-1244 stock.
  • You must have paid for the stock with money or other property. The stock issued must be issued in exchange for cash or other property. Stock issued in exchange for other stocks doesn't qualify, and stock issued for services rendered doesn't qualify either. Also, special rules apply to the valuation and treatment of property that was exchanged for the stock. If you contribute property to the corporation, you should familiarize yourself with these rules.
  • Most of the company's gross receipts must be from operations. For a period of the corporation's most recent five years ending before the date of the loss, gross receipts from royalties, rents, dividends, interest, annuities, and sales or exchanges of stock or securities must not exceed 50% of the receipts of the company. If the company has been in business less than five years, the testing period applies to all the years the company has been in existence. This gross receipts test does not apply, however, if during the applicable period, the aggregated amount of deductions exceeds the aggregate amount of gross income. To have this exception apply, the company must be an operating company; it can't be an investment company.
  • As owner of the 1244 stock, you must be an individual, or a partner in a partnership, which holds 1244 stock.
  • You must have acquired the stock after June 30, 1958.
  • If the stock was acquired before November 7, 1978 the stock was issued under a written plan that met the requirements of section 1244.
  • You have held the stock continually as an individual, or partnership, since the date the stock was issued.

If all of these requirements are met, you should report the loss, up to the maximum limitation, on line 10 of Form 4797. You should report any loss in excess of the limit on Schedule D, Form 1040.

By Intuit Inc.

 

 
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