Purchasing shares in a company is a sound investment strategy that offers tangible benefits if properly executed. Small businesses and startup investors typically see substantial returns if they’re successful. But, private equity investing is a risky business, so some companies issue section 1244 stock to protect shareholders against losses. The in-depth guide will explain section 1244 stock and what it means for small business owners.
What is a Section 1244 Stock?
Section 1244 stock is a special class of security that offers tax benefits and incentivizes investment in a company.
The term gets its name from IRS Code Section 1244. If you sell shares of a smaller business for a loss, the IRS taxes it as an ordinary loss.
However, the IRS still imposes a capital gains tax rate on any Section 1244 profits. So, you get the best of both worlds. Whether you gain or lose, Section 1244 stock provides more favorable tax treatment.
Taxpayers pay the capital gains rate on stock profits, and any losses fall under the more beneficial ordinary loss tax rate.
Section 1244 allows for up to a $50,000 loss on an individual tax return and $100,000 for a joint return. However, only small, US-based companies can elect for this special tax treatment.
Section 1244 Stock Definition
“Section 1244 stock is a stock transaction pursuant to the Internal Revenue Code provision that allows shareholders of an eligible small business corporation to treat up to $50,000 of losses (or, in the case of a husband and wife filing a joint return, $100,000) from the sale of stock as ordinary losses instead of capital losses. The statutory text of Section 1244 can be found at 26 U.S.C. § 1244.”
Potential Benefits of Issuing Sect. 1244 Stock
For smaller businesses and startups, issuing section 1244 stock is highly beneficial. Investing in a new or small business is inherently risky.
Studies show roughly 20% of small businesses fail in their initial year of business. This percentage increases to around 50% by the fifth year of business.
Issuing 1244 stock incentivizes investment by mitigating the inherent risks with favorable tax outcomes. If your business is attempting to raise funds, these benefits could make your company a much more attractive investment.
The lifespan of a section 1244 stock starts when it’s issued. In most cases, any sale of stock is a capital loss or gain. When a capital loss occurs, there are limitations on how much of these losses an investor can deduct on their taxes. Section 1244 stock gets rid of these limitations and allows the investor to deduct all losses below $50,000.
The shareholders that are eligible for section 1244 stock include individuals, LLCs, and partnerships. As such, small businesses benefit from issuing this stock because it’s available to the majority of potential shareholders.
Section 1244 stock’s loss rules are its primary benefit. The IRS treats what would typically be capital losses as ordinary losses. As a result, you can deduct your losses in the year that they occur.
However, ordinary losses don’t directly offset capital losses. So, firms can still access lower capital gains tax rates without worrying about capital losses dragging down their gains.
Ordinary losses are able to reduce taxable income for the year. If losses qualify as ordinary losses via section 1244, these losses will be classified as business losses or trade losses as well. As such, you can more accurately calculate your net operating loss.
You can factor your section 1244 stock losses into your net operating loss calculation. As a result, you can avoid limits on your non-business income.
The gain rules for section 1244 stock are simple and straightforward. Any profits you generate from the stock are taxed under the more favorable capital gains tax rate. Since your losses are ordinary and your gains are capital, you can benefit directly from lower tax rates.
Section 1244 Qualifications
The IRS has some criteria for issuing and purchasing Section 1244 stock, including:
- The shareholder must purchase the stock instead of receiving it as a form of compensation
- Domestic corporations must issue the stock as preferred or common stock
- When the business issues the section 1244 stock, the total capital that it has access to must be below $1 million with less than 50% of income coming from passive investments
- A shareholder who receives section 1244 stock must cannot exchange it via a private transaction or market
- Most of the company’s revenues must come directly from operations instead of dividends, royalties, and interest
How Can Small Business Register for Section 1244?
Stock only qualifies under this treatment when shareholders claim it on their tax forms. But, the company has to adhere to the above qualifications for the shareholders to claim this benefit.
If you qualify, you can claim a section 1244 loss on Form 4797.
The company that wants to register for section 1244 will need to show that 50% or less of their income came from passive investments in recent years. The total capital that they have will also need to be less than $1 million at the time that the stocks are issued.
Is Issuing Section 1244 Stock Worth It?
Section 1244 stock carries notable benefits for both companies and investors. It greatly mitigates shareholder risk and incentivizes small business investment. It allows investors can deduct large portions of their investment losses, and business can attract more investors thanks to Section 1244’s favorable tax treatment.
Sect. 1244 Tax Strategies
Business can tap into tremendous benefits with this type of security, but they should be aware of the tax implications. Talk to a Tax Hack pro today to learn more about how Section 1244 stock can impact your business’s tax situation. Our experts are standing by to assist you with all of your toughest tax questions. Get started now and see how much you can save with Tax Hack.