Investing in a small business can be a risky endeavor. Congress, however, has provided incentives to taxpayers willing to take the risks.
A capital gain or loss may occur when stock is sold or exchanged. If the selling price is greater than the purchase price, the transaction results in a gain. If the selling price is lower than the purchase price, a loss occurs. Section 1244 provides tax benefits in loss situations, whereas Sections 1202 and 1045 provide relief in gain situations.
Losses on certain small business stock. The sale of stock at a loss usually generates a capital loss, which can only be deducted in any particular year to the extent of capital gains, plus $3,000. Fortunately, Congress recognizes that investors in small corporations often run more of a risk of loss. As a result, the Internal Revenue Code permits an individual to deduct, as an ordinary loss, a loss from sale or exchange, or from worthlessness, of “small business stock” (more commonly called “Code Sec. 1244 stock”) issued by a qualifying small business corporation. Unlike a capital loss, an ordinary loss may fully offset wage income, dividends, or similar “ordinary” income.
To qualify as stock entitled to an ordinary loss deduction (Section 1244 stock); stock must be issued by a domestic corporation that is a small business corporation at the beginning of the tax year in which the stock is issued. A corporation is a small business corporation if the total amount of cash and other property received by the corporation for stock, as a contribution to capital and as paid-in surplus, does not exceed $1 million. If this $1 million threshold is exceeded, only a portion of the corporation’s stock can qualify as Section 1244 stock.
In addition to being issued by a small business corporation, to prove that it is an active business rather than a quasi-holding company, two other corporate-level tests must be met to qualify the stock as Section 1244 stock:
- The small business corporation must have more than 50 percent of its aggregate receipts derived from noninvestment income; and
- It must be largely an operating company deriving more than 50 percent of its gross receipts from actual nonpassive sources. Investment income for this purpose includes only gross receipts derived from royalties, rents, dividends, interest, annuities, and sales or exchanges of stock or securities.
There are limits, however, to the tax advantages of using Section 1244 stock. The maximum amount deductible as an ordinary loss in any one year is $50,000 ($100,000 on a joint return). However, any amounts in excess may qualify for carryback and carryover provisions. Corporations, estates and trusts are ineligible for this tax-favored treatment.
Gains on qualified small business stock. Special provisions within the Tax Code not only protect investors from the downside with Section 1244 stock; the Tax Code also provides favorable treatment on the upside for gains from investing in small business stock under Section 1202. For stock acquired after September 27, 2010, individual investors may exclude 100 percent of the gain they realize on the disposition of qualified small business stock if it is held for more than five years. However, for stock acquired after February 17, 2009 and on or before September 27, 2010, the exclusion from gain is 75 percent, and for stock acquired after August 10, 1993 and on or before February 17, 2009, the exclusion from gain is 50 percent. Unlike losses under Section 1244, a small business for purposes of sheltering gain is defined more broadly to include a corporation with gross assets of less than $50 million at issuance. The amount taken into account under this exclusion is limited to the greater of $10 million or ten times the taxpayer’s basis in the stock. The amount of gain eligible for the partial exclusion is subject to limits computed on a per-issuer basis.
Additionally, Section 1045 allows any investor that has held small business stock for more than six months may elect to sell it and defer any gain to the extent that he uses the amount realized on the sale to buy, within 60 days of the sale, any stock that also qualifies as small business stock. The holding period of the stock purchased under this swap provision generally includes the holding period of the stock sold.
Please keep in mind that California does not conform to all the tax provisions listed above. If you have invested or plan on investing in small business stock and would like more information on the various tax benefits discussed above, please contact your L&B professional for more information. The rules can be quite complex, but the benefits of qualifying for these special provisions may have significant tax ramifications.