|Deadline for designating Section 1244 stock
The required designation for shares evidenced by a certificate having serial numbers or letters must be made not later than the 15th day of the third month following the close of the transitional year (Mar. 15 for a calendar year corporation).
How to designate stock issued in transitional year
A corporation designates stock issued in a transitional year (first taxable year in which the corporation's capital receipts exceed $1,000,000, as Section 1244 stock by entering the numbers of the qualifying share certificates on the corporation's records. Designation in the corporate minutes qualifies.
Illustration: On Dec. 1, Corporation W, a newly- formed corporation, issues 10,000 shares of common stock at $125 a share of an amount of money and other property totaling $1,250,000. The board of directors specifies that 8,000 shares are Section 1244 stock and records the certificate numbers of the qualifying shares in its minutes. Because W issued stock in exchange for money and other property exceeding $1,000,000 but has designated shares of stock as Section 1244 stock, and the designated shares were issued in exchange for money and other property not exceeding $1,000,000 (8,000 shares × $125 per share, the 8,000 designated shares qualify as Section 1244 stock.
Which corporations can issue Section 1244 stock—the “small business corporation” rule.
A domestic small business corporation is the only corporation that can issue Section 1244 stock. A domestic corporation is one organized or created in the U.S., including only the states and the District of Columbia, or under the law of the U.S. or of any state or territory. The determination as to whether a corporation qualifies as a domestic corporation may be made at or before the time the stock is issued.
Observation: There is no limit on the number of shareholders a corporation can have for Section 1244 stock purposes.
S corporations as “small business corporations.”
The rules governing S corporations require those corporations to be small business corporations. The term small business corporation has a different meaning for purposes of Subchapter S than it has for purposes of Code Sec. 1244. Accordingly, all stock of an S corporation, even if original issue stock, is not automatically Section 1244 stock. S corporation stock will be Section 1244 stock only if the requirements are met. The fact that an S election has not been filed has no bearing on the question of whether the corporation qualifies as a small business corporation.
Observation: Qualifying as Section 1244 stock is just as important for S corporations as for a regular corporation. For example, an S corporation may sustain little or no operating losses, but the value of its assets may decrease. If the S corporation is then liquidated or sold, the shareholder's loss on the transaction will be a capital loss unless the stock was Section 1244 stock.
Recommendation: Try to qualify all newly issued S corporation stock as “Section 1244 stock.” There's nothing to lose and everything to gain from doing this. A failed attempt to qualify does not otherwise affect the corporation.
How to claim the ordinary loss on Section 1244 stock
Claim the ordinary loss from Section 1244 stock on Form 4797
You have asked me to explain the rules regarding a loss which you sustained on the sale of stock in your closely-held corporation.
Ordinarily, a loss on a sale or exchange of stock is a capital loss. Capital loss treatment is generally less advantageous than ordinary deduction treatment because of the fact that a capital loss recognized by an individual is applied, first against capital gain (which is usually subject to tax at a maximum marginal rate which is lower than that on ordinary income), and, to the extent it exceeds capital gains recognized during the year, is subject to limitations on deductibility.
Fortunately, the tax law allows ordinary loss treatment on certain losses with respect to stock of small corporations. In general, this special treatment is only available if the following conditions are satisfied:
(1) As of the time the stock was issued, the aggregate amount that was received by the issuing corporation for stock, as contributions to capital and as paid-in surplus, must not have exceeded $1 million.
(2) The stock must have been issued for money or property (other than stock or securities). Thus, the stock can't be issued as compensation for services.
(3) 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.
(4) The taxpayer claiming the special treatment must be an individual (including, if certain conditions are satisfied, individuals who claim the loss through holding an interest in a partnership that is selling the stock). The special treatment isn't available to corporations, trusts or estates.
(5) The stock must have been issued to the individual claiming the special treatment, or to the partnership through which the individual is claiming the special treatment, and held continuously by that individual (or partnership) to the time of sale.
In any year, the total loss treated as ordinary under these rules can't be more than $50,000 (or $100,000 if you file a joint return).
I'd be happy to discuss the application of these rules to your specific situation. If you would like to discuss this, or have any other questions, please give me a call.
Very truly yours,