Say you’re contemplating an investment in a new business venture. It’s somewhat risky, given the current economic conditions, but you may want to help a relative or friend get the business off the ground.
Unfortunately, if things don’t pan out, the loss would have limited tax value.
Strategy: Invest in Sec. 1244 stock. That way, as long as certain requirements are met, you can write off up to $100,000 if the business fails.
Basically, investing in Sec. 1244 stock is like getting a form of tax insurance from Uncle Sam without paying extra premiums for the coverage.
Here’s how it works: Normally, if a taxpayer invests in a new business, any resulting loss is treated as a capital loss. The loss must first be used to offset capital gains and then up to $3,000 of ordinary income from salary, interest, etc.
However, under Sec. 1244 of the tax code, you can claim an ordinary-loss tax deduction for a loss on stock from a “qualified small business corporation.” The loss is fully deductible against ordinary income as well as any capital gains. Single filers can deduct up to $50,000 of losses from Section 1244 stock in any one year, while joint filers can deduct up to $100,000.
To qualify for Section 1244 treatment, these requirements must be met:
- The corporation must issue the stock directly to the investors. They can’t acquire the stock from another shareholder and deduct a loss against ordinary income.
- The stock must be acquired in exchange for cash or property contributed to the corporation. Investors can’t receive the shares as compensation for their services.
- A “small business corporation” must issue the stock. For this purpose, a small business corporation is defined as a corporation with invested capital of $1 million or less. It can be an S corporation or a regular C corporation.
- The corporation is an actual, operating company. During the past five years, the corporation 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 been in existence.
Don’t confuse this tax break for selling qualified small business stock (QSBS). That’s a separate tax provision (see Pocket tax breaks for small biz investments: Buy QSBS).
Tip: Sec. 1244 applies only to losses, not gains. If the business is successful, long-term gains from selling the stock generally are treated as capital gains taxed at the maximum 15% rate.