Thinking Loss? Think Section 1244
I recently received a call from a client who, over the last few years, has loaned a substantial amount of money to his son for his don’t restaurant. The business is not going well at present and may eventually fold. My client said, “I read about a Section 1244 stock that can be written off as a loss greater than $3,000 per year. What can you find out for me?” I began by calling an accountant.
He said, “Yes, you can write off more than $3,000 annually, but you must meet certain conditions.” That put me on the trail. Here’s where it lead.
According to statistics published by the American Bankruptcy Institute, there was an average of 59,765 business bankruptcies per year in the united States between 1980 and 2000. This statistic indicates that people lost most, if not all, of the capital they in-vested into these businesses. To add insult to the injury, they can only write- off $3,000 of their losses annually. However, had they followed the rules of Internal Revenue Code Section 1244, they could have written off up to $100,000 in losses in a year.
Let’s go over some tax income and loss basics first. Assume that you invest money in a stock or directly into a business. If that business makes money, it can pay you a dividend. Dividends used to be taxed at ordinary income rates as high as 35%. However, recent tax law changes have dropped the tax on dividends to 15% for most people (for those people in the 10% or 15% bracket, qualifying dividends will be subject to a maximum tax of only 5%). This is a good thing!
Now let’s look at capital gains and losses. If the company continues to make money and pay a dividend, chances are the price of its stock will worth $20. If you sell it within the year of purchase, you would pay a tax on the gain as ordinary income (that can be 35%). If, on the other hand, you held the stock for more than a year and then sold it, you’d be taxed at the lower capital gains rate that is now 15% (or lower if you don’t have much income).
Assuming that you invested $100,000 in the above company in which the share price doubled, you’d be sitting on a $100,000 gain. If you took the gain within the year of purchase, you’d owe $35,000 in tax. If you waited un-til the 366th day, you’d owe $15,000. So much for gains, now, for losses.
Let’s assume you invested the same $100,000 but the opposite happens; the stock moves form $20 per share to $10, and you’ve held the stock for over a year. You are left with a $50,000 loss. While you can offset any capital gains in a year against the $50,000 loss, you can only carry $3,000 of the loss annually in the future. Ignoring any future capital gains, it will take 16 years to complete the write-off. Sound unfair? Don’t look for fairness in the tax code because the art of government is to take mo-ney form one group and give it to another.
Okay, you are aware of this problem and you are asked to invest in a new company. You’ve done your home-work and the business looks like a go, and to make things more interesting a relative is pitching it. It would be in your best interest to have the company stock issued to you as Section 1244 stock because you can write-off up to $100,000 in a year, in you file a joint return should things head south.
In order to qualify as Section 1244 stock there are several requirements. It must be a small, domestic company, i.e. receipts cannot be over $1,000,000. You must pay for your stock with cash or property; you cannot pay for your share with other stock or services rendered. Most of the company’s gross receipts must come from operations. For a period of the corporation’s gross receipts must come form operations. For a period of the corporation’s most recent five years ending before the date of the loss, gross receipts from royalties, rents, dividends, interest, an-nuities, and sales or exchanges of stock or securities must not exceed 50% of the company’s receipts. In other words, this must be an operating company, not an investment company.
Additionally, the owner of the 1244 stock must be an individual or a partner in a partnership, which holds 1244 stock. And the stock must have been acquired after June 30, 1958. If ac-quired before November 7, 1978, the stock must have been issued under a written plan that met the requirements of Section 1244. Further more, the stock must have been held continually as an individual, or partnership, since the date the stock was issued.
So what about my client? Unfortu-nately, he is a loaner to the business and not an owner. Even if he were, the company was not set up as a Section 1244.