How Section 1244 Helps Investors in New Businesses

I receive all kinds of requests for advice, many coming from those hoping to become entrepreneurs, investors and lenders. Over the last couple of months, these types of requests have increased, perhaps because of investors who are rattled by the changes in securities markets.  

This series will be devoted to answering recent queries from entrepreneurs and investors who have questions about Section 1244 of the Internal Revenue Code, the small business stock provision. 

One investor, Maxine, is planning to move money into a new furniture company. Unfortunately, many new or refinanced enterprises experience enormous losses, especially in their earliest years of operation. Or, even worse, they go belly up. Before Maxine actually transfers funds, she should bone up on how to take maximum advantage of a tax break that’s available only if the new company designates the newly issued shares as Section 1244 stock. 

Unfortunately, many accountants, attorneys, enrolled agents, financial planners and other tax experts are unaware that Section 1244 characterizations allow clients who hold shares of smaller companies to alleviate financial pain significantly in the event that the business fails. Of course, helping clients deal with failure is one of those time-tested ways for accountants to build their practices and enhance relationships. Still, a client will dump her adviser once she becomes aware––too late, of course––of how easily she could have trimmed her taxes by designating her shares as 1244 stock. 

Lawmakers crafted Section 1244 to provide no-cost “tax insurance” for investors in undertakings that go sour, hoping to make it easier for small companies to entice investment capital. Section 1244 helps shareholders who suffer losses on the sale or worthlessness of their shares because it authorizes faster-than-normal deductions for such losses, provided the shares meet the requirements for 1244 stock.

Here’s what does and doesn’t happen in the year that 1244 shares are sold, exchanged or become worthless. 

What doesn’t happen? The IRS says it doesn’t require investors to comply with Code Section 1211’s restrictive rules for claiming capital losses. When Section 1211 ceases to be applicable, Section 1244 permits investors to take ordinary-loss deductions of as much as $100,000 for joint filers and $50,000 for single filers as offsets against ordinary income. Those caps aren’t annually indexed to reflect intervening inflation. 

Qualification under Section 1244 is not easy. A key restriction is that Congress capped the aggregate amount of money or other property that a new business can receive for the 1244 stock and previously issued stock. The amount generally can’t exceed $1 million.

Section 1211 allows an investor to claim annual capital-loss deductions, though it caps her write-offs at $3,000. But when an investor’s shares satisfy the requirements of Section 1244, she’s able to avail herself of a better option. Section 1244 allows joint filers to claim ordinary-loss write-offs of up to $100,000 ($50,000 for single filers and married couples who submit separate returns) as offsets against ordinary income, with no indexing of the ceilings to reflect inflation. 

Ordinarily, Section 1211 imposes the rules that permit investors to take capital-loss deductions for losses on sales, exchanges or worthlessness of stocks. Consequently, capital losses may be of limited value for an investor in the absence of any capital gains from other business or personal investments. Unfortunately for her, many years might elapse before she can completely use up sizable capital losses.

The rules are burdensome due to the previously discussed annual ceiling of $3,000 for joint and single filers (it drops to $1,500 for married couples who file separate returns) on the amount of net capital losses that they’re allowed to offset salaries and other kinds of ordinary income. 

When an investor has unused capital losses for the year in question, Section 1212(b) allows her to carry such losses forward and claim them in the same way on her 1040s for later years until she completely uses them up.

The standard rules for capital losses don’t apply to losses on 1244 stock. More favorable rules kick in for the year that 1244 shares are sold or become worthless. Section 1244 allows investors to claim ordinary-loss deductions of as much as $100,000 for married couples who submit joint returns and $50,000 for single persons and married couples who decide to submit separate 1040s. 

Lawmakers approved indexing for the income tax brackets and for the standard deduction amounts that are available to filers who opt not to use Form 1040’s Schedule A to itemize write-offs for things like medical expenses (allowable only to the extent that they exceed 7.5 percent of adjusted gross income), payments for interest on mortgages for personal residences (allowable within limits) and charitable contributions.

Add to the list payments for state and local income taxes, property taxes and sales taxes. They were capped at $10,000 for the years 2018 through 2025 by the Tax Cuts and Jobs Act passed by Congress and the former president near the close of 2017. But those lawmakers decided not to approve indexing for the caps of $100,000 and $50,000. In fact, those amounts have remained virtually the same since 1978, when the previous $50,000 and $25,000 were replaced by the current (for 43 years and counting) $100,000 and $50,000 amounts.

The term “ordinary income” is IRS argot for income from such sources as salaries, profits from businesses or professional practices, rental income, interest and pension payments. Also taxed as ordinary income are withdrawals from traditional IRAs, 401(k)s and various other kinds of tax-deferred retirement plans. It makes no difference whether those subtractions are obligatory, as when seniors must make required minimum distributions, or voluntary, as in the case of Roth conversions.

What’s next. Part two in this series will further discuss how the 1244 rules help or hurt investors when they suffer losses on sales or exchanges of shares that satisfy the 1244 requirements or their shares became worthless.