Definition of 'Section 1244 Stock'

A type of equity named after the portion of the Internal Revenue Code that describes its
treatment under tax law. Section 1244 of the tax code allows losses from the sale of shares of
small, domestic corporations to be deducted as ordinary losses instead of as capital losses up to a
maximum of $50,000 for individual tax returns or $100,000 for joint returns.
To qualify for section 1244 treatment, the corporation, the stock and the shareholders must meet
certain requirements. The corporation's aggregate capital must not have exceeded $1 million
when the stock was issued and the corporation must not derive more than 50% of its income
from passive investments. The shareholder must have paid for the stock and not received it as
compensation, and only individual shareholders who purchase the stock directly from the
company qualify for the special tax treatment. This is a simplified overview of section 1244
rules; because the rules are complex, individuals are advised to consult a tax professional for
assistance with this matter.
Section 1244 of the Internal Revenue Code, the small business stock provision, was enacted to
allow shareholders of domestic small business corporations to deduct as ordinary losses, losses
sustained when they dispose of their small business stock. In order to receive this beneficial
treatment, the Code prescribes specific requirements for: (1) the corporation issuing the small
business stock; (2) the stock itself; and (3) the shareholders of the corporation.
(1) The corporation issuing the stock must qualify as a domestic small business corporation,
which generally means that it must be created under the laws of the United States and that its
aggregate capital must not exceed $1,000,000 at the time the 1244 stock is issued to its
shareholders. The first taxable year in which the capital of the corporation exceeds $1,000,000 is
called the transitional year, and the corporation must designate which shares issued that year
qualify for 1244. For example, if a newly formed corporation received $2,000,000 for its initial
issue of stock, it could designate up to $1,000,000 of its stock as qualified 1244 stock.
The corporation must also satisfy a gross receipts test. This test requires that the corporation,
during the period of its five most recent years ending before the date the loss on its stock was
sustained, derive more than 50% of its gross receipts from sources other than passive investment
income. The gross receipts test thereby confines the tax relief provided by the small business
stock provision to the stock of corporations actively engaged in a trade or business. The gross
receipts test does not apply where, for the entire period for which gross receipts are measured,
the gross income of the corporation is less than the business deductions allowed to the
corporation by the Code.

The Code also imposes recordkeeping requirements on the corporation relative to its 1244
stock. Among these is requirement that the corporation designate designation, for its transitional
year, those of its outstanding shares that qualify for small business stock treatment.
(2) Common stock, and preferred stock issued after July 18, 1984, qualifies as 1244 stock. In
order to qualify as 1244 stock, the stock must be issued, and the consideration paid by the
shareholder must consist of money or other property, not services. Stock and other securities are
not "other property" for this purpose. However, cancellation of indebtedness may be sufficiently
valid consideration.
(3) Section 1244 is available only for losses sustained by shareholders who are individuals.
Losses sustained on stock held by a corporation, trust or estate do not qualify for 1244
treatment. Subject to very limited exceptions, the benefits of 1244 are only available to
individuals who acquire the stock by issuance from a domestic small business corporation, and
are not available to a subsequent transferee of the stock. In some cases, a partnership can qualify
as a shareholder of 1244 stock. Generally, all transfers of 1244 stock by the shareholder,
whether in a taxable or nontaxable transaction, whether by death, gift, sale or exchange,
terminate 1244 status.
Once all of the requirements of 1244 stock are met, ordinary loss treatment for losses on a sale
or exchange of 1244 stock is permitted if the loss would otherwise be treated as a capital loss.
The amount of ordinary loss that an individual taxpayer may realize by reason of the small
business stock provision is subject to certain limitations. Any amount of 1244 loss in excess of
this limitation is treated as a capital loss. For losses incurred in taxable years beginning after
1978, the maximum amount that a taxpayer may claim as an ordinary loss for all losses sustained
on 1244 stock in a taxable year is $50,000, generally, or $100,000 if a joint return is filed.