Unfortunately, not all startup companies become the next Snowflake and turn into one of the largest IPOs in the history of the U.S. stock exchanges. In fact, many are not successful. If one of your emerging company investments has failed, you may be surprised to learn that the investment could still yield immediate favorable tax benefits.
Using IRC Section 1244
Section 1244 of the Internal Revenue Code (IRC) allows an annual ordinary loss deduction for “worthless stock” up to $100,000 for a married couple filing jointly, and $50,000 for an individual filing single. For example, if $100,000 was invested by a married couple filing jointly with a 37% marginal rate, and that corporation’s stock became entirely worthless in early 2020, that may translate into a $37,000 tax reduction/potential refund of their 2020 tax liability. This has the effect of turning a completely worthless investment into a $37,000 recovery. Investments not qualifying for this special write off rule may only yield a capital loss that could take years to produce any tax benefit (due to the limits on capital loss deductions).
At a high level, IRC Section 1244 was originally enacted into the tax law to provide income tax incentives for individuals to make new investments into small businesses. The theory goes something like this: the larger the number of early stage companies, the higher the probability of another successful company and, of course, very successful employees. At some point, these successful employees may spin off and form their own successful Section 1244 qualified businesses, thus perpetuating the U.S. entrepreneurial economic life cycle.
Does Your Failed Investment Qualify?
IRC Section 1244 includes a myriad of rules. Here is a summary of five general rules to help you gain a quick glimpse into whether your stock may qualify:
- The stock must have been issued by a qualifying U.S. domestic corporation, including an S Corporation.
- At the time the stock is issued, the corporation must have shareholder’s equity of less than or equal to $1 million (caveat being that special rules apply in the year the equity exceeds $1 million).
- The stock must have been issued in exchange for cash or property (but not stock).
- At least half of the corporation’s earnings from the past five years or the life of the company (whichever is less) before the stock became worthless must have been derived from active business operations and not from passive activities.
- The individual claiming the loss must have received the stock in a direct issue from the corporation. (Stock received by way of a gift or inheritance doesn’t qualify).
For many companies and investors, the qualifications may be easily met. For other situations, additional investigation and documentation may be required.
In summary, a failed investment in a small company may generate a significant tax benefit if it falls within the IRC Section 1244 rules. If you are wondering if you hold an investment that is eligible for Section 1244 treatment, contact your Clark Nuber tax advisor before year end to discuss qualification and potential tax benefits.
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