Do you own a C corporation, an S corporation, or a partnership? Or do you own stocks in these companies? If so, I would like to give you information about the potential tax benefit of investing in a small domestic corporation under section 1244 of the tax code, which includes S Corporations. Essentially, section 1244 allows losses sustained from the disposition of stocks in a small domestic corporation to be deducted as ordinary losses instead of capital losses for shareholders who hold these stocks. Under the tax code, capital losses are subject to a $3,000 limit, whereas section 1244 allows you to deduct the full ordinary loss for a small business stock if certain requirements are met. This benefit can also go to owners of an S Corporation who are also individual shareholders. For example, if as the owner of the corporation/small business, you sell your stock for a loss or liquidate the business, you can deduct the full amount of your loss against your ordinary income rather than just $3,000 maximum, up to a limit of $50,000 for the year.
In order to qualify for this benefit, the corporation's aggregate capital must not have exceeded $1,000,000 at the time the stock was issued to the shareholders, the stock must have been issued in exchange for cash or property, and not as compensation or in exchange of services or securities, and the corporation must pass the "gross receipts test." The gross receipts test requires that the corporation, during the period of its five most recent years that ended before the date the loss on its stock was sustained, derived more than 50% (half) of its gross receipts from sources other than passive investment income. Essentially, the small domestic corporation must be actively engaged in a trade or business in order to qualify its shareholders for this tax relief.
In addition, section 1244 is available only for losses sustained by shareholders who are individuals. Losses sustained on stock held by a corporation or a trust do not qualify. The individual shareholder must have directly acquired the stock by issuance from the domestic small business corporation and not by a subsequent transfer from a previous owner.
This is a very brief overview of this complicated topic, but it is worth noting that a serious investor or owner of an S Corporation should be aware of this potential tax benefit.