Allocating allowable sec. 1244 loss among shareholders when total capital exceeds $1 million.

• Author: Ellentuck, Albert B.

Facts: On june 1, 1979, newly formed ABC Corporation authorized 600,000 shares of common stock to be issued with a $1 par value. On june 5, 1979, 300,000 shares were issued at par to Alan and 300,000 shares were issued at par to Bill. On June 30, 1981, ABC authorized the issuance of another 600,000 shares of common stock on July 1, 1981. Of these additional 600,000 shares, 100,000 were issued to Alan, 100,000 to Bill and 400,000 to a new shareholder, Connie. All stock was issued in exchange for cash. ABC was always actively engaged in the manufacturing industry. It was fairly successful the first few years, but as the local economy worsened it began incurring large losses. On Jan. 31, 1996, ABC was forced into bankruptcy. The stock was declared worthless in 1996. 9 Both Alan and Bill are married and file joint returns. Connie is single. Taxable income for the three for 1996 before application of the Sec. 1244 loss is as follows: Alan, $175,000; Bill, $156,000; and Connie, $78,000. None of the three have any capital gains in 1996. Issue: What portion of each shareholder's stock loss can be treated as an ordinary loss?

Analysis

The original issuance of ABC's stock on june 5, 1979, in the amount of $600,000, qualifies as Sec. 1244 stock. 1. The total amount contributed to capital and paid-in surplus at that time was $1 million or less. 2. The stock was common stock originally issued to qualified shareholders in exchange for cash. 3. Because ABC was actively involved in the manufacturing business, it is reasonable to assume that the gross receipts test would be met.

However, the issuance of $600,000 of additional stock on July 1, 1981 brought ABC's total capital to $1.2 million. At that point, the small business corporation limitation of $1 million was exceeded. The excess will not qualify as Sec. 1244 stock and will be subject to capital loss treatment. The year 1981 is the "transitional year" because the issuance of stock exceeded the $1 million limitation in that year. Any stock issued after that date will not qualify as Sec. 1244 stock.

A corporation may designate which shares issued in the transitional year are Sec. 1244 shares. In the absence of a proper designation by the corporation, the following formula is used to compute the Sec. 1244 loss permitted on any individual's disposition of the stock:

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Assuming ABC did not make a Sec. 1244 designation on the issuance of stock in 1981, the shareholders must...