Section 1244 Stock: Ordinary Loss on Small Business Stock

How it works

A loss on stock that is sold at a loss or becomes worthless is a capital loss. It offsets capital gains first, and whatever is left offsets ordinary income at $3,000 a year, $1,500 on a married-filing-separately return, with the balance carried forward indefinitely under Sections 1211(b) and 1212(b).

Section 1244 changes the character of that loss for a narrow class of stock. An individual the stock was issued to, or a partner who was already a partner when the partnership acquired it, treats the loss as an ordinary loss instead: deductible in full against any income, dollar for dollar, subject to an annual limit of $50,000, or $100,000 on a joint return. Sections 1244(a) and (b). Anything above the limit falls back to the capital-loss rules.

The limit is the whole mechanism. Section 1244 does not make the loss bigger; it makes part of it usable in the year the money was lost, against any income on the return. The limit runs per taxpayer, per year, not per corporation.

There is no election to make, and for stock issued after November 6, 1978 no written plan to adopt either, so the treatment applies automatically once the statutory tests are met, subject to the designation rule below. Treas. Reg. Section 1.1244(c)-2(b).

The dollar limits are fixed, and nothing indexes them

$50,000 and $100,000 are the only two figures Section 1244(b) names, and it reserves the larger one for an actual joint return under Section 6013. Read literally, every other filing status gets the full $50,000, married filing separately included: Section 1244(b) has no halving clause for a separate return, unlike the $3,000 and $1,500 capital-loss offset in Section 1211(b). Neither figure is indexed; both have been flat since the Revenue Act of 1978 raised them from the 1958 enactment's $25,000 and $50,000.

What this is worth in Florida

Nothing at the state level, and I would rather say so plainly. Florida has no individual income tax and does not tax pass-through income at the personal level, so turning a capital loss into an ordinary one changes no Florida result. The entire benefit is federal.

Who this applies to

Section 1244 attaches to how the stock was acquired, not to who holds it when the loss happens. That is what does most of the filtering.

• The claimant has to be an individual. Either the individual the stock was issued to, or an individual who was a partner in a partnership when it acquired the stock. Section 1244(a); Treas. Reg. Section 1.1244(a)-1(b). Trusts and estates are excluded by definition: Section 1244(d)(4) writes them out of the word individual.
• A single-member LLC collapses into its owner. One that has not elected corporate treatment is disregarded as separate from its owner under Treas. Reg. Section 301.7701-2(a), so stock issued to it counts as issued to the owner. A multi-member LLC taxed as a partnership follows the partnership rule.
• The issuer can be a C corporation or an S corporation. Section 1244(c)(1) says domestic corporation in its opening text and stops there; subparagraph (A) is the separate small-business-corporation test. That is the biggest practical divergence from the qualified small business stock exclusion in Section 1202, which requires a domestic C corporation and is foreclosed by an S election. A domestic S corporation's own stock, issued directly to its shareholder, can be section 1244 stock.
• There is no excluded-fields list. Section 1202(e)(3) names service fields that can never issue qualified small business stock. Section 1244 has no equivalent, so an accounting, law, health or consulting corporation is not barred from issuing it.

Whether an S election is the right wrapper for a Florida business is a separate question, one I work through in my Florida S-corp guide.

Original issue, and nothing else

The stock has to have been issued directly to the claimant, or to the partnership, at original issue. Treas. Reg. Section 1.1244(a)-1(b) is blunt about what that rules out:

An individual who acquires stock from a shareholder by purchase, gift, devise, or in any other manner is not entitled to an ordinary loss under section 1244 with respect to this stock.

A buyer on a secondary transfer, a donee and an heir are permanently outside the provision, however the shares reached them. Ordinary-loss character does not run with the stock the way basis and holding period do, and a partner to whom the partnership later distributes the shares loses eligibility going forward.

Continuous holding is a distinct requirement from original-issuee status, and the two are easy to hear as one. The same regulation requires the claimant to have held the stock continuously from issuance through the loss, so an original issuee who transferred the shares away and later reacquired them fails the second test.

What it requires

The remaining conditions sit on the corporation and the stock, each tested against facts fixed at issuance.

• Small business corporation status, measured by capital received. At the issuance in question, the corporation must have received $1,000,000 or less in aggregate money and other property for stock, as a contribution to capital, and as paid-in surplus. Section 1244(c)(3)(A). The test is cumulative, counting that stock and all stock issued before it. Property other than money counts at the corporation's adjusted basis, less any liability assumed. Section 1244(c)(3)(B).
• Consideration of money or property, not services and not securities. Section 1244(c)(1)(B) excludes stock issued in exchange for other stock or securities, and stock issued for services. Treas. Reg. Section 1.1244(c)-1(d)(1) extends the services exclusion to stock received under an option granted in whole or part for services.
• More than half of gross receipts from active sources. Across the corporation's five most recent tax years ending before the loss, or its whole life if younger, more than 50 percent of aggregate gross receipts has to come from sources other than royalties, rents, dividends, interest, annuities, and gains on sales or exchanges of stock or securities. Section 1244(c)(1)(C) and (c)(2). The test is waived where aggregate deductions exceeded aggregate gross income for that period, Section 1244(c)(2)(C), so an unprofitable operating company is not penalized for looking passive on paper.
• Preferred stock, if issued after July 18, 1984. Treas. Reg. Section 1.1244(c)-1(b) still reads that only common stock may qualify, but that text predates the statute: the Deficit Reduction Act of 1984 substituted stock for common stock in Section 1244(c)(1) for stock issued after the July 18, 1984 enactment date, and the regulation was never updated to match.
• An affirmative designation, once a raise crosses the ceiling. When an issuance would push cumulative capital receipts past $1,000,000, only shares within the ceiling can be section 1244 stock, and the corporation has to identify those shares, by certificate number or equivalent, in a written corporate record. Treas. Reg. Section 1.1244(c)-2(b).
• A second cap on a partner. A partner who clears the timing gate is still held to the lesser of their distributive share when the stock was issued or when the loss is sustained. Treas. Reg. Section 1.1244(a)-1(b).

What you need to document

Treas. Reg. Section 1.1244(e)-1 sets out the records behind this. For stock issued after November 6, 1978 only the designation record is mandatory and the rest is recommended recordkeeping, but most of it has to exist at issuance rather than at the loss. None of it is enforced at the moment it is created, and by the point a loss makes it matter, the records that decide the question are already years old.

The original-issue record

The subscription agreement, the cap-table entry, the date, and what was paid. Where property rather than cash was contributed, its fair market value and the corporation's adjusted basis in it.

The corporation's running capital total

Money and property received for stock, as contributions to capital, and as paid-in surplus, accumulated from formation. It is the only way to show each issuance was still inside the $1,000,000 ceiling.

The designation record, where one was required

Where a later round crossed the ceiling, the written record identifying which shares are section 1244 stock. Without it, shares beyond the ceiling do not qualify even though earlier rounds did.

The gross-receipts computation

The five-year aggregation behind the active-business test, broken out to show which receipts were royalties, rents, dividends, interest, annuities, or gains on stock and securities.

Enough detail to tell the shares apart

One corporation can hold section 1244 stock and non-qualifying stock at once, from a later round or from shares issued for services. For a partner claimant, add both years of allocation percentages.

The loss computation that travels with the return

The ordinary portion goes on Form 4797, Part II, line 10, entered as losses on section 1244 small business stock, with an attached computation showing how the total loss was derived and split. Part II ordinary losses flow to Schedule 1 of Form 1040, not Schedule D.

Any excess above the annual limit goes on Form 8949 and Schedule D as a capital loss, short or long term under the normal holding-period rules; section 1244 changes how much of the loss is ordinary, not the character of the rest. That excess then behaves like any other capital loss, at $3,000 a year with an indefinite carryforward under Sections 1211(b) and 1212(b), the mechanics behind tax-loss harvesting.

Where it goes wrong

This is not a listed or reportable transaction. Section 1244 is relief Congress wrote deliberately, so the risk is not aggressiveness. It is eligibility and documentation, concentrated at issuance.

• No proof of original issue. The single most common failure. Stock acquired by purchase, gift or inheritance is categorically ineligible under Treas. Reg. Section 1.1244(a)-1(b), and the cap-table and subscription records are the entire defense.
• Capital receipts already over $1,000,000 at that issuance. If the corporation had crossed the ceiling when the round went out, that round's stock never qualified, and it cannot be cured afterward. Section 1244(c)(3)(A).
• Reading the Section 1202 test as if it were this one. Section 1202 gates on aggregate gross assets; Section 1244 on capital received for stock. Different measurements at very different ceilings, so passing one says nothing about the other.
• A missing designation on the round that crossed the ceiling. Shares beyond $1,000,000 are not section 1244 stock unless the corporation affirmatively designated the qualifying ones. Treas. Reg. Section 1.1244(c)-2(b).
• Consideration that turns out to have been services. Stock issued for services, or in exchange for other stock or securities, is not section 1244 stock. Section 1244(c)(1)(B).
• Writing off the gross-receipts test too early. A passive-heavy corporation that was nonetheless profitable can look like a failure here when the Section 1244(c)(2)(C) escape actually applies.
• Property contributed at a basis above its value. Where property exchanged for the stock had an adjusted basis above its fair market value, Section 1244(d)(1)(A) reduces the stock's basis, for loss purposes, by that excess.
• Partner timing. A partner admitted after the partnership acquired the stock, or one who received it through a later distribution, gets no ordinary-loss treatment. Treas. Reg. Section 1.1244(a)-1(b).

One question the sources do not settle

Section 1244(d)(3) treats a section 1244 ordinary loss as attributable to a trade or business of the taxpayer, but it says so for net operating loss purposes specifically. Whether it also counts as a trade-or-business deduction for the separate excess business loss limitation in Section 461(l) is addressed neither by that provision nor by the current Form 461 instructions, which define trade or business by the taxpayer's own regular and continuous profit-motivated activity. Passively holding stock in someone else's corporation does not obviously meet that. I treat the point as genuinely unsettled, and a taxpayer near the Form 461 threshold needs it researched rather than assumed.

A situation where this comes up

The recurring pattern is a founder who put cash directly into a corporation they formed, took original-issue stock for it, never sold or gifted a share, and watched the business fail. The company raised well under $1,000,000, ran a real operating business, and had gross receipts from operations rather than investments. The stock became worthless.

Without section 1244 that loss is a capital loss, and the arithmetic surprises people. With no capital gains to absorb it, the taxpayer deducts $3,000 a year and carries the rest forward, so on a six-figure loss the deduction arrives across decades. Section 1244 does not change the size of the loss; it changes how much is usable now, and shrinks the carryforward by the same amount.

There is a trap in this pattern specific to an S corporation, unrelated to section 1244's own tests. Under Section 1367, a shareholder's stock basis is reduced each year by their share of pass-through losses and by distributions, so a company that limped through several loss years may have consumed the basis long before the terminal event. Section 1244 can only recharacterize a loss that basis still supports.

The loss event is a sale, an exchange, or worthlessness, and where it is worthlessness Section 165(g) governs when the loss is treated as sustained, which decides which year's limit applies. What I would flag hardest is that nearly everything deciding this happened at issuance. By then the corporation's capital history, the consideration paid, and who the shares were issued to are all fixed. Section 1244 either applies or it does not.