Claiming ordinary losses for Sec. 1244 stock.

• Author: Ellentuck, Albert B.

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SEC. 1244 ENCOURAGES NEW INVESTMENT in small business by permitting investors to claim an ordinary (rather than a capital) loss on the disposition (including worthlessness) of qualifying small business stock. As an added benefit, any loss that qualifies as an ordinary loss under Sec. 1244 is also treated as a trade or business loss in computing an individual's net operating loss (NOL). Thus, Sec. 1244 losses are allowed for NOL purposes without being limited by nonbusiness income.

An annual limitation is imposed on the amount of Sec. 1244 ordinary loss that is deductible. The maximum deductible loss is $50,000 per year ($100,000 if a joint return is filed) (See. 1244(b)). Any loss in excess of the limit is a capital loss, subject to the capital loss rules. Thus, if the potential loss exceeds the $50,000 (or $100,000) limit, the stock should be disposed of in more than one year to maximize the ordinary loss treatment.

Example 1: In 1998, M contributed $150,000 cash to his corporation, N Co., in exchange for stock. The business never attained the success M originally envisioned. In 2008, M sold his stock This case study has been adapted from PPC's Guide to Tax Planning for High Income Individuals, 9th Edition, by Anthony J. DeChellis, Patrick L.Young, James D.Van Grevenhof, and Delia D. Groat, published by Thomson Tax & Accounting, Ft.Worth, TX, 2008 ((800) 323-8724; ppc.thomson.com). to an unrelated party for $40,000. M's tax loss on his sale of stock is $110,000 ($40,000 proceeds--$150,000 stock basis). The stock qualified as Sec. 1244 stock. M files a joint return with his wife, L.

In the year of sale, M can claim a $100,000 ordinary (Sec. 1244) loss deduction and a $10,000 capital loss. If M has no 2008 capital gains, his capital loss is limited to $3,000 (with the balance carried forward), but his ordinary deduction is allowed in full in 2008, assuming he has adequate taxable income.

Example 2: Now assume instead that M sells 90% of his N stock in 2008 for $36,000 and the remaining 10% in early 2009 for $4,000. M's tax loss on his 2008 stock sale is $99,000 [$36,000 proceeds--($150,000 stock basis x 90%)]. M's tax loss on his 2009 stock sale is $11,000 [$4,000 proceeds --($150,000--$135,000)]. By structuring the sale of stock over two years, M is able to avoid the $100,000 annual limitation on Sec. 1244 losses. Therefore, M can claim a $110,000 ($99,000 in 2008 + $11,000 in 2009) ordinary (Sec. 1244) loss deduction...