New Business Saving Opportunity

Individuals are opting to start new businesses at a rapid pace. This phenomenon is likely the result of various reasons including the slow economy, early retirement, and folks just wanting to get away from the everyday grind of working for someone else. If you are considering fulfilling the dream of owning your own business, you might consider a tax planning opportunity that exists if you own and operate that new business through a corporate entity.

As you may be aware, gains and losses on sales of corporate stock generally are treated as capital gains and losses. Although capital gains are potentially taxed at preferential rates, capital losses are usually unattractive because the losses can only offset capital gains plus $3,000 ($1,500 if married filing separate) of ordinary income (from wages, dividends, interest, etc.). Any remaining balance is carried over to future years. Thus, if you realize large capital losses but no capital gains, the tax benefit of the capital losses may have to be spread over many years.

There is a tax provision, however, that allows you to treat losses incurred from the sale of qualified corporate stock as ordinary (rather than capital) losses. That is beneficial because an ordinary loss offsets ordinary income. The deductible ordinary loss for this provision is 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 the Section 1244 stock provision) is like insurance—you hope you will not need it but it is nice to have just in case. Any gain realized on the sale of Section 1244 stock is considered capital gain. However, losses realized are characterized as ordinary losses. Thus, there is really no downside to qualifying for Section 1244 treatment if your initial capital structure can be set up to meet the requirements.

Only original owners of the corporate stock are eligible for Section 1244 treatment. 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 property (other than stock or securities). Stock issued in exchange for services will not qualify. In addition, the corporation generally 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.

Note that individuals purchasing the stock of an existing corporation are not entitled to Section 1244 treatment since they are not the original owner of the stock. In this situation, investors can purchase the corporation’s assets and transfer them to a new corporation that is eligible for Section 1244 treatment.