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Why Section 1244 Stock is a Worthy Investment

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Section 1244 shares can be an attractive option for new businesses and their investors. In this article, tax expert Julian Block explains the Section 1244 rules and why 1244 shares that are sold or become worthless stocks can actually benefit an investor.

Jan 27th 2022
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If you’re just joining in, I recommend that you read the first part in this series. There, I summarize the Section 1244 rules and explain how these rules can affect investors. This article, part two, will focus on additional aspects of the rules.

In the year that 1244 shares are sold or become worthless, investors aren’t constrained by the restrictive rules for capital losses that are imposed by Section 1211, as previously discussed. Instead, Section 1244 permits these investors to claim ordinary-loss deductions. Deductions top off at $100,000 for married couples who file joint 1040s and $50,000 for single persons and married persons who file separate 1040s. 

The faster-than-usual write-offs for 1244 stock cover more than shares bought from companies that are just starting out. They also cover shares later bought from outfits in need of additional capital. Tucked into the regulations for 1244 stock is a relief provision for married couples who opted not to put their holdings into joint ownership. According to this provision, a married couple needn’t hold the stock jointly to qualify for the top deduction of $100,000. In addition, they needn’t have been married when the stock was issued. 

If an investor’s 1244 loss is $110,000, while her spouse’s is zero, she can deduct $100,000 on a joint return. However, her remaining $10,000 falls under those less-favorable 1211 rules. Assume, instead, that her loss is significantly north of the limit of $100,000. It would behoove her to unload her shares gradually because the limit is a yearly basis, not a restriction on total losses from 1244 stock. If she can spread the loss over more than one year, more than $100,000 can qualify for ordinary-loss treatment.

This possibility is quite attractive, and accountants should keep in mind that it’s just one of the many reasons that choosing the 1244 option warrants consideration in many new business situations.

For instance, let’s say an investment of $220,000 in a business proves to be unsuccessful, and the investor can unload her stock for $20,000. She sells 50 percent of her stock for $10,000 in December of year one and does the same in January of year two. She then qualifies for an ordinary write-off of $100,000 each year––a total of $200,000.

On the other hand, if an investor’s loss is south of the limit of $100,000, she’ll receive the identical tax protection provided to a partner or sole proprietor who suffers a loss on the worthlessness of his or her business. As a result, the investor can avoid operating as a partner or proprietor. Of course, incorporation might have been a better strategical choice for reasons that have nothing to do with taxes––for instance, freedom from liability.

Partnerships. The regulations provide guidelines for partners in a partnership that owns 1244 stock. Individuals who were partners when the stock was issued receive ordinary-loss deductions for the loss sustained by the partnership; the limit of $100,000 or $50,000 is determined separately for each partner. Different rules apply when a partnership distributes the shares to any partners who then turn around and sell, realizing the loss. They have to treat their as capital, not ordinary.

What’s next. Part three will discuss additional aspects of the rules, such as paperwork requirements and preempting audits.

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