How to Qualify for Section 1244 Stock

If you’re just joining us, the first three parts in this series summarized the Code Section 1244 rules and explained what happens when investors sell their shares or they become worthless. Investors aren’t limited to the usual capital-loss deduction of no more than $3,000. Instead, they can claim ordinary-loss deductions of as much as $100,000 for joint filers and $50,000 for single filers as offsets against ordinary income.

This article, part four, will conclude the series by explaining what requirements the IRS says corporations have to satisfy to qualify under Section 1244.

Getting the treatment. Qualification under Section 1244 isn’t automatic. The IRS understandably imposes some restrictions on this benefit.

For starters, the 1244 shares must be common or preferred stock of a U.S. corporation that’s issued in exchange for money or property other than stock or securities. This stipulation disqualifies any stock issued in payment for services rendered or to be rendered. Bonds don’t qualify. While sweat equity doesn’t work, cash or property does.

Another limitation is that the aggregate amount of money or other property received by the corporation for the 1244 stock and previously issued stock generally can’t exceed $1 million. When a company later surpasses the $1 million cap, it’s not a problem, according to the IRS. Stock previously issued in prior years that was otherwise eligible stays eligible, according to the agency. There are no ceilings, however, on the number of shareholders, size of profits and so on.

Also, Section 1244 mandates that a company has to engage in business, rather than investment, activities in order to qualify. Generally, it must derive more than 50 percent of its aggregate gross receipts for the five years (or all years of existence, if less) preceding the year of the loss from business operations and not from what 1244 regulations dub “passive sources” –– specifically, royalties, rents, dividends, interest, annuities and gains from sales or exchanges of stock or securities.

Finally, the stock must be held continuously by the same individual (or partnership) from the time of issuance to the time of loss. The requirement that the stock be newly issued bars an ordinary-loss deduction for someone who acquires1244 stock by purchase, gift, inheritance or in any other manner from a person who was the original purchaser of the shares. Only the original owner qualifies for the 1244 break.

In the case of an already-existing corporation, the newly issued requirement is easy to sidestep. Just follow these steps: Purchase all of the company’s assets, transfer them to a new company and have it issue 1244 stock.

When shares fail to pass muster under Section 1244, should a client later incur a loss, it’ll be capital, not ordinary. However, that’s not what’ll happen if a client’s company decides not to issue 1244 stock when it sets up a business or issues new stock for a going venture that needs additional capital. Hence, there are no drawbacks to issuing 1244 stock.

A reminder for the accounting community: A million dollars is not chopped liver. Congress crafted the 1244 rules to encourage investments in small businesses––those, as noted above, with a paid-in-capital of $1 million or less. High failure rates for those kinds of ventures notwithstanding, the 1244 provision for writing off losses provides some compensation. Although the process of applying for 1244 status sometimes gets complex, it’s usually simple. Accountants should encourage clients who start or invest in new businesses to hope for the best, yet plan for the worst, thereby gaining a competitive advantage in the accounting marketplace.