Tax Matters

Favorable tax treatment for stock issued by closely held corporations

By David Katzman

If you purchased stock in a closely held corporation and have since sold the stock at a loss or it has become worthless, there may be some good news from a tax perspective.

Such losses are usually considered capital losses, which are not treated favorably under current Internal Revenue Service (IRS) regulations. Generally, capital losses must offset capital gains. If a taxpayer has more capital losses than gains, they can be used in a very limited manner to offset other ordinary income. 

For taxpayers involved in small corporations, which issued stock that qualifies as Section 1244 Stock, any losses suffered can be used directly to offset ordinary income up to $50,000 for individuals and $100,000 for taxpayers who file jointly, any remaining excess will be subject to the capital loss rules.

There are some tests that must be met before the corporation and its shareholders qualify for Section 1244 Stock and the special tax treatment. Here are the requirements: 

• One million dollar limit: When the stock was issued the corporation’s total contributions for the issuing stock (for all stockholders) cannot exceed $1 million. In other words, Section 1244 Stock is reserved for small corporations.
• Money or property must have been received: If you have been issued this stock, it must have been in return for money or property contributions. Section 1244 Stock cannot be issued as compensation for services, such as in lieu of salary.
• Passive income limitations: For the five years before the year the loss was sustained, the corporation must not have received 50% or more of its receipts from certain passive sources.
• The taxpayer must meet certain requirements: The special tax treatment associated with Section 1244 Stock is not available to corporate entities, trusts or estates. Generally, the taxpayer taking the loss claims must be an individual. However, if certain conditions are met, holding the stock via a partnership interest may also qualify. 
• Continuous holdings: The1244 stock cannot be acquired by another individual who intends to take the 1244 loss. The stock must have been issued to the taxpayer claiming the loss, or to a qualifying partnership including the taxpayer. Additionally, the stock must have been held continuously by that individual or partnership until the loss is recognized.

David A. Katzman is a certified public accountant licensed to practice in the State of Florida and the Commonwealth of Massachusetts. He is also a certified financial planner and certified senior advisor. Please consult your tax advisor for details and assistance in applying this general information to your specific situation.