Section 1244 Stock: An Exception To Capital Loss

I was looking at a case involving Section 1244 stock.

I remember studying Section 1244 in school. On first impression one could have expected it a common quiver in tax practice. It has not been.

What sets up the issue is the limitation on the use of capital losses. An easy example of a capital asset is stock. Buy and sell stock and you have capital gains and losses (exempting those people who are dealers in stocks and securities). You then net capital gains against capital losses.

·      If the result is net capital gain, you pay tax.

·      If the result is net capital loss, the Code allows you to deduct up to $3,000 of net loss against your other types of income.

QUESTION: What if the net loss is sizeable – say $60 grand?

ANSWER: The Code will allow you to offset that loss dollar-for-dollar against any future capital gains.

QUESTION: What if the experience left a mark? You have no intention of buying and selling stocks ever again.

ANSWER: Then we are back to the $3,000 per year.

Mind you, that $3,000 entered the Code back in 1978. A 1978 dollar is comparable to $4.82 in 2024 dollars. Just to keep pace, the capital loss limit should have been cumulatively raised to $14,460 by now. It has not, of course, and is a classroom example of structural anti-taxpayer Code bias. 

Section 1244 is there to relieve some of the pressure. It is specialized, however, and geared toward small businesses.

What it does is allow one to deduct (up to) $50 grand ($100 grand for joint returns) as an ordinary loss rather than a capital loss.

There is a downside: to get there likely means the business failed. Still, it is something. Better $50 grand at one time than $3 grand over umpteen years.

What does it take to qualify?

(1)  First, there must be stock. Being a partner in a partnership will not get you there. This means that you organized as a corporation. Mind you, it can be either a C or an S corporation, but it must be a corporation.

(2)  The corporation must be organized in the United States.

(3)  The total amount of capital contributions to the corporation (stock, additional capital, whatever) must not exceed $1 million. If you are the unfortunate who puts the number above $1 million, then some of your stock will qualify and some will not.

(4)  The capital contribution must be in cash or other property (excluding stocks and securities). This would exclude stock issued as compensation, for example.

(5)  You must be the original owner of the stock. There are minimal exceptions (such as inheriting the stock because someone died).

(6)  You must be an individual. Corporations, trusts, estates, trustees in bankruptcy and so on do not qualify.

(7)  There used to be a prohibition on preferred stock, but that went out in 1985. I suppose there could still be instances involving 1984-or-earlier preferred stock, but it would be a dwindling crowd.

(8)  The company must meet a gross receipts test the year the stock is issued.

a.    For the preceding five years (or life of the company, if less), more than 50% of aggregate gross receipts must be from active business operations.

b.    Another way to say this is that passive income (think interest, dividends, rents, royalties, sales or exchanges of stocks and securities) had better be less than 50% of aggregate gross receipts. This Code section is not for mutual funds.

An interesting feature is that no formal election is required. Corporate records do not need to reference Section 1244.  Board minutes do not need to approve Section 1244.  Nothing needs to go with the tax return. The corporation must however retain records to prove the stock’s qualification under Section 1244.

And therein can be the rub.

Let’s look at the Ushio case.

In 2009 David Ushio acquired $50,000 of common stock in PCHG.

PCHG in turn had invested in LifeGrid Solutions LLC (LGS), which in turn was seeking to acquire rights in certain alternative energy technology.

PCHG never had revenues. It ceased business in 2012 and was administratively dissolved by South Carolina in 2013.

The IRS selected the Ushio’s joint individual return for 2012 and 2013. The audit had nothing to do with Section 1244, but the IRS saw the PCHG transaction and allowed a $3,000 capital loss in 2012.

Mind you, the Ushios had not claimed a deduction for PCHG stock on either their 2012 or 2013 return.

Mr. Ushio said “wait a minute …”

Some quick tax research and Ushio came back with a counter: he wanted a $50,000 ordinary loss deduction rather than the puny $3,000 capital loss. He insisted PCHG qualified under Section 1244.

The IRS had an easy response: prove it.

Ushio was at a disadvantage. He had invested in PCHG, but he did not have inside records, assuming those records even existed.

He presented a document listing “Cash Input” and “Deferred Pay,” noting that the deferred amount was never paid. Sure enough, the amount paid-in was less than $1 million.

The IRS looked at the document and noted there was no date. They wanted some provenance for the document - who prepared it? what records were used? could it be corroborated?

No, no and no.

In addition, PCHG never reported any gross receipts. It is hard to prove more-than-50% of something when that something is stuck at zero. Ushio pushed back: PCHG was to be an operating company via its investment in LGS.

The IRS could do this all day: prove it.

Ushio could not.

Meaning there was no Section 1244 stock.

Our case this time was Ushio v Commissioner, T.C. Summary Opinion 2021-27.

 

Qualifying For Stock Loss Under Section 1244

 

I am looking at a case having to do with Section 1244 stock.

And I am thinking: it has been a while since I have seen a Section 1244.

Mind you; that is not a bad thing, as Section 1244 requires losses. The most recent corporate exit I have seen was a very sweet rollup of a professional practice for approximately $10 million. No loss = no Section 1244.

Let’s set up the issue.

We are talking about corporations. They can be either C or S corporations, but this is a corporate tax thing. BTW there is a technical issue with Section 1244 and S corporations, but let’s skip it for this discussion.

The corporation has gone out of business.

A corporation has stock. When the corporation goes out of business, that stock is worthless. This means that the shareholder has incurred a loss on that stock. If he/she acquired the stock for $5,000, then there is a loss of $5,000 when the corporation closes.

Next: that loss is – unless something else kicks-in – a capital loss.

Capital losses offset capital gains dollar-for-dollar.

Let’s say taxpayer has no capital gains.

Capital losses are then allowed to offset (up to) $3,000 of other income.

It will take this person a couple of years to use up that $5,000 loss.

Section 1244 is a pressure valve, of sorts, in this situation.

A shareholder can claim up to $50,000 of ordinary loss ($100,000 if married filing joint) upon the sale, liquidation or worthlessness of stock if:

 

(1)  The stock is be either common or preferred, voting or nonvoting, but stock acquired via convertible securities will not qualify;

(2)  The stock was initially issued to an individual or partnership;

(3)  The initial capitalization of the corporation did not exceed $1 million;

(4)  The initial capitalization was done with stock and property (other than stock and securities);

(5)  Only persons acquiring stock directly from the corporation will qualify; and

(6)  For the five tax years preceding the loss, the corporation received more than 50% of its aggregate gross receipts from sources other than interest, dividends, rents, royalties, and the sale or exchange of stocks or securities.

The advantage is that the ordinary loss can offset other income and will probably be used right away, as opposed to that $3,000 year-by-year capital loss thing.

Mind you, there can also be part Section 1244/part capital loss.

Say a married couple lost $130,000 on the bankruptcy of their corporation.

Seems to me you have:

                      Section 1244                     100,000

                      Capital loss                         30,000

Let’s look at the Ushio case.

Mr Ushio acquired the stock of PCHG, a South Carolina corporation, for $50,000.

PCHG intended to was looking to get involved with alternative energy. It made agreements with a Nevada company and other efforts, but nothing ever came of it. PCHG folded in 2012.

Ushio claimed a $50,000 Section 1244 loss.

The IRS denied it.

There were a couple of reasons:

(1)  Mr. Ushio still had to prove that $1 million limit.

 

The issue here was the number at the corporate level: was the corporation initially capitalized (for cash and property other than stock and securities) for $1 million or less? If yes, then all the issued stock qualified. If no, the corporation must identify which shares qualified and which shares did not.

        

It is possible that PCHG was not even close to $1 million in capitalization, in which a copy of its initial tax return might be sufficient. Alternatively, PCHG’s attorney or accountant might/should have records to document this requirement.        

 

(2)  PCHG never had gross receipts.

 

This means that PHGC could not meet the 50% of gross receipts requirement, as it had no gross receipts at all.

 

Note that opening a savings or money market account would not have helped. PCHG might then have had gross receipts, but 100% of its gross receipts would have been interest income – the wrong kind of income.

Mr Ushio did not have a Section 1244 loss, as PCHG did not qualify due to the gross-receipts requirement. You cannot do percentages off a denominator of zero.

My first thought when reviewing the case was the long odds of the IRS even looking at the return, much less disallowing a Section 1244 loss on said return. That is not what happened. The IRS was initially looking at other areas of the Ushio return. In fact, Ushio had not even claimed a capital loss – much less a Section 1244 loss – on the original return. The issue came up during the examination, making it easy for the IRS to say “prove it.”

How would a tax advisor deal with this gross-receipts hurdle in practice?

Well, the initial and planned activity of PCHG failed to produce any revenues. It seems to me that an advisor would look to parachute-in another activity that would produce some – any – revenues, in order to meet the Section 1244 requirement. The tax Code wants to see an operating business, and it uses gross receipts as its screen for operations.

Could the IRS challenge such effort as failing to rise to the level of a trade or business or otherwise lacking economic substance? Well, yes, but consider the alternative: a slam-dunk failure to qualify under Section 1244.

Our case this time was Ushio v Commissioner, TC Summary Opinion 2021-27.