Here’s a positive outgrowth of this pandemic – Abo and Company is excited to witness an uptick in entrepreneurial activities (unemployment be damned), Still, starting a new business venture almost always involves some level of risk since things are so challenging now. Unfortunately, not all startup companies succeed and many do fail.  If this occurs, all is not lost however. In what may otherwise be considered a complete loss, there are at least potential tax benefits available to certain original individual shareholders of corporations in this position.  So, here’s what Abo and Company has suggested to our next would-be Jeff Bezos.

After we go through the thought process of selecting the type of entity to select, if a corporation is the most favorable (versus, say, an LLC), we recommend issuing Section 1244 stock for this newly incorporated venture. As long as certain requirements are met, the entrepreneur/investors can claim an ordinary loss of up to $100,000 if the venture is unsuccessful and the stock is ultimately sold for a loss

Under normal circumstances, when you invest in corporate stock, any resulting loss on its sale is treated as a capital loss where the loss can offset capital gains and then up to $3,000 of ordinary income generated from salary, dividends, interest, etc. Excess capital losses are then carried forward.

Under Section 1244 of the Internal Revenue Code, an ordinary loss deduction for a loss on stock from a “qualified small business corporation” can offset ordinary income and any capital gains. You can deduct up to $100,000 of losses from Section 1244 stock in any one year if you file a joint return ($50,000 if single).

To qualify under Section 1244, these five requirements must be adhered to:

1. The stock must be acquired in exchange for cash or property contributed to the corporation. Investors cannot receive shares as compensation for their services. However, cancellation of indebtedness may be sufficiently valid consideration.

2. The corporation must issue the stock directly to the investors. They cannot acquire the stock from another shareholder (so gifts or inheritance of the shares won’t work).

3. The corporation must be an actual, operating company. During the past five years, it must have received less than 50% of its gross receipts from rents, royalties, dividends and other investment income. If the corporation is less than five years old, this test applies to the years it’s existed.

4. The stock must be issued by a “small business corporation” defined as a corporation with invested capital of $1,000,000 or less. It can be an S corporation or a C corporation.

5. The entity must be a domestic corporation.

The Abo and Company “win-win” comes into play in that this Section 1244 “benefit” applies to losses while there is still a break for gains.  Assuming no “Post-election” changes, a long-term capital gain that results from the sale of this Section 1244 stock will be taxed at the regular preferential rate of 15% for most individuals or 20% for high-income individuals. The 3.8% Net Investment Income Tax (NIIT) may also be due.

Section 1244 of the Internal Revenue Code is the small business stock provision enacted to allow shareholders of domestic small business corporations to deduct a loss on the disposal of such stock as an ordinary loss rather than as a capital loss, which is limited to only $3,000 annually.

A loss on Section 1244 stock is reflected on Form 4797 of your personal income tax return, not Schedule D.

We recommend that when the corporation is set up, corporate records should document that the stock issued qualified as Section 1244 stock.  We always want to be at least prepared for the potential of an IRS audit where they may request to see corporate records to ensure there is reference to Section 1244. The Company and the individual shareholders should retain information about the qualifying stock purchased (i.e. number of shares received, date the stock was issued and price paid for the stock).

If a partnership purchases Section 1244 stock of another corporate entity and later disposes of the stock at a loss, the partnership entity may pass the ordinary loss through to its partners. Note that for a partner to claim the loss as an ordinary loss instead of a capital loss, the partner must have been a partner when the stock was originally issued and remained so until the time of the loss.  We just learned in preparing this alert that If the partnership entity owns Section 1244 stock and distributes the stock to its partners, they may not claim an ordinary loss on their disposition (i.e. sale) of the stock, instead, capital loss treatment applies

Alas, if an S corporation owns Section 1244 stock and passes a loss on the stock to its shareholders, they may not deduct the loss as an ordinary loss. Instead, they must deduct the loss as a capital loss.

Martin H. Abo, CPA/ABV/CVA/CFF is a principle of Abo and Company, LLC and its affiliate, Abo Cipolla Financial Forensics, LLC, Certified Public Accountants – Litigation and Forensic Accountants.  With offices in Mount Laurel, NJ, Morrisville, PA and Franklin Lakes, NJ. Marty can be reached at marty@aboandcompany.com   or by calling 856-222-4723.