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.
