I would like to add 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. Section 1244 allows you to deduct the full ordinary loss for a small business stock if certain requirements are met. You can deduct up to $50,000 as ordinary loss. Any amount over $50,000 will be treated as a capital loss subject to the $3,000 limit.
It is not just a shareholder of a smal domestic corporation who sells his small business stock for a loss that can deduct. The owner of an S Corporation who is also an individual shareholder can deduct as well. For example, if as the owner of the corporation, you sell your stock for a loss or liquidate your business, you can deduct the full amount of your loss (up to $50,000) against your ordinary income rather than just $3,000 maximum.
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, 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.
Section 1244 is only available 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 stock in a small business should be aware of this potential tax benefit.