How do you get ordinary loss when you close down your corporation?

By Jeffrey Brooks, CPA, CFP, MBA for Jbrooks Wealth Advisors, PC, a Professional CPA and CFP Firm 602-687-9900 x101

Being allowed to deduct a loss on Section 1244 stock as an ordinary loss rather than a capital loss is the tax benefit.
If you own stock in a qualifying small corporation and the business fails causing its stock to become worthless, you can claim an ordinary loss, up to certain limits, against your other sources of income.
You must be the original purchaser of the stock to qualify for ordinary loss treatment.
An ordinary loss is more beneficial than a capital loss because it is fully (100%) deductible in a tax year.
A capital loss is only deductible up to a maximum of $3,000 per year. Any excess capital loss over $3,000 must be carried over to the next tax year.

Up to $50,000 ($100,000 MFJ) of
losses from the sale, exchange or worthlessness of Section 1244
stock qualifies for ordinary loss treatment. A Section 1244 loss can
create or add to a current-year NOL for the shareholder. Losses
from Section 1244 stock in excess of the $50,000 ($100,000) limit
are treated as capital losses.
For stock to qualify under Section 1244, the corporation must be
a small business corporation at the time the stock is issued. For
this purpose, a small business corporation is one in which total
capital contributions and paid-in surplus do not exceed $1 million.

What are the other requirements for Section 1244 stock?
1) Common stock, and preferred stock issued after July 18, 1984,
in a domestic corporation qualify for Section 1244 treatment.
[IRC §1244(c)(1)]
2) Generally, the business must have been incorporated after
November 6, 1978.
3) The stock must be in the hands of the shareholder to whom
originally issued.
4) The shareholder cannot be a corporation, trust or estate.
5) The stock must be issued in exchange for money or property
(not for stock, securities or services).
6) Gross receipts test. For the five years ending before the loss
(or the tax years of the corporation’s existence if less than five),
the corporation must have derived more than 50% of its gross
receipts from sources other than royalties, rents, dividends,
interest, annuities and gains from sales and exchanges of stocks
or securities. Only net gains (not gross receipts) from sale or
exchange of stock or securities are considered. Losses on the
sale of one security do not offset gains on another. If the Section
1244 loss is realized during the corporation’s first tax year, the
test period starts the first day of the tax year and ends the day
before the loss is sustained. [Reg. §1.1244(c)-1(e)]

Where do you report the ordinary loss?

Losses from the sale of qualified Section 1244 stock are reported on Form 4797.
What do you need to keep in mind?
–Qualification as Section 1244 stock is determined at the time
the stock is issued, except for the gross receipts test. The gross
receipts test applies at the time a loss is realized.
–The corporation is not required to make any special designation for
1244 treatment, except in the year capital receipts exceed $1 million.
In the year of transition, the corporation must keep records that
designate certain shares as Section 1244 stock [Regs. §1.1244(c)-2
and §1.1244(e)-1(a)]. However, it is advisable for the corporation to
keep detailed records about issuance of stock and gross receipts
for all years to assist shareholders in claiming losses.

How do you come up with the Basis of Section 1244 Stock?

The basis of Section 1244 stock is limited to the original capital
contribution paid directly for the stock. Future increases in overall
basis will not increase the amount allocated to Section 1244 stock.
If the shareholder contributes additional capital after the original
stock purchase, the allowable loss under Section 1244 is allocated
in proportion to original basis to total basis. [Reg. §1.1244(d)-2]
Actual Loss × Original Basis = Section 1244 Loss Total Basis

Example: Herman contributes $10,000 to Herman Corporation in exchange for 100
shares of stock.

One year later, he contributes an additional $2,000 to the capital of the corporation,
increasing his basis to $12,000.

Eight years later, the corporation is liquidated and Herman receives $1,000 cash in
exchange for his stock.

Of the $11,000 actual loss, $9,167 is an ordinary loss under Section 1244 and the remaining $1,833 is a capital loss.

What have the court said in it’s Rulings?

Several court cases and IRS rulings have addressed the issue of capital contributions made after an initial purchase of Section 1244 stock.

Court Case #1: Two individuals agreed to pay business expenses out of their
personal funds in exchange for stock in a corporation. Even though the resulting
capital contributions were made over a period of time, the court ruled that
the amounts were a direct purchase of the stock, relying in large part on the
original intent of the shareholders. The Tax Court overruled a previous IRS
determination and allowed the taxpayers to treat the entire amount paid as
basis under Section 1244. (Miller, TC Memo 1991-126)

Court Case #2: In another case, the court determined that the amount originally
paid for stock ($7,500) was the only amount allowable under Section 1244.
Subsequent contribution of capital of $189,000 was considered “allocable to
stock which is not Section 1244 stock.” (Bledsoe, TC Memo 1995-521)
Copyright 2011 Thomson Reuters. All Rights Reserved.
2011 Tax Year | Premium Quickfinder® Handbook 17-7

What is a smart tax planning strategy?

Careful planning of stock purchases can preserve the benefits of Section 1244 for shareholders. Especially if there is
a significant risk of loss on investment in Section 1244 stock, the purchaser should make sure additional shares are issued for each contribution made to capital. If shares are purchased over time, as in the case of agreement to pay corporate expenses in exchange for stock, a written plan should be drafted and carefully followed.

What happens if Partnerships or S corporation’s shareholders are the owners of a C Corporation?
If a partnership acquires Section 1244 stock and later sells at a loss, an ordinary loss deduction may be claimed only by individuals who were partners when the stock was issued. However, loss incurred by an
S corporation on the sale of Section 1244 stock cannot be passed on to the shareholders as an ordinary loss [Reg. §1.1244(a)-1(b)]. They must treat the loss as a capital loss.

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About Jeffrey Brooks

Jeffrey Brooks, CPA, CFP, MBA since 1976 has specialized in helping clients save significant taxes, help businesses increase their cash flow, revenues and profits while increasing their control and satisfaction. Jeff and his accounting firm sincerely cares about the happiness of his clients.

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JBrooks Wealth Advisors, PC.

Certified Public Accountant
Address: 4647 N 32nd Street, Suite B245
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Phone: 602-292-2009