Tax Advantages of Small Business Stock
personally are generally treated as capital gains and losses. Although capital gains are potentially taxed at preferential rates, capital losses are usually unattractive because they can only offset capital gains plus $3,000 ($1,500 for married filing separate returns) of ordinary income (from wages, dividends, interest, etc.). Thus, if you realize large capital losses—but no capital gains, the tax benefit from the capital losses may have to be spread over many years in the future.
However, there is a tax provision that allows you to treat losses incurred from the sale of qualified corporate stock as an ordinary (rather than capital) loss. That’s beneficial because an ordinary loss offsets ordinary income. The deductible ordinary loss for this provision is, however, subject to an annual limitation of $50,000 ($100,000 if you file a joint return).
Of course, you don’t intend for your new business to generate a loss; however, this tax provision (known as Section 1244) is like insurance—you hope you will not need it, but it’s nice to have just in case. Any gain on the sale of Section 1244 stock is capital gain and qualifies for the favorable capital gains tax rates. Only losses are characterized as ordinary. Thus, there’s really no downside to qualifying for Section 1244 treatment if your initial capital structure can be set up to meet the requirements.
To qualify as Section 1244 stock, your new business must be a U.S. corporation (including an S corporation), and it must have no more than $1 million in capitalization at the time the stock is issued. The stock must be issued to an individual or partnership in exchange for money or qualified property. Stock issued in exchange for services will not qualify. In addition, the corporation must derive more than half of its gross receipts from noninvestment activities for a specified period (generally, five years) before the year the stock is disposed of at a loss.