How to Tax-Proof a Business Venture
April 13, 2012
Virtually any new business undertaking in 2012 is likely to be a risky proposition. At least entrepreneurs and investors can secure some tax protection under Section 1244 of the Internal Revenue Code. If certain requirements are met, a Section 1244 shareholder can claim a tax loss of up to $100,000 if the business goes under, without any dollar limit on profits. Background: In the normal course of events, a shareholder treats a loss from a failed business venture as a capital loss for tax purposes. The loss may be used to offset any capital gains realized during the year plus up to $3,000 of highly taxed ordinary income. Any excess loss is carried over to future years. Therefore, it may take a long time to write off large investment losses. For example, say that a taxpayer incurs a $50,000 loss from a business venture and expects to have an offset of $10,000 a year for the foreseeable future. It could take five years to recover the full tax benefit of the loss. Conversely, Section 1244 allows the taxpayer to claim a bigger deduction on a loss from a small-business investment. The loss is completely deductible against ordinary income, after offsetting capital gains, within an annual limit. A single filer can deduct up to $50,000 of losses from Section 1244 stock in one year. The annual limit for joint filers is $100,000. To qualify for this special tax treatment, these four key requirements must be met: 1. The corporation must issue the stock directly to the shareholders. In other words, a shareholder cannot acquire the stock from another taxpayer and deduct a loss against ordinary income. 2. The stock must be acquired in exchange for cash or property contributed to the corporation. For instance, a shareholder cannot receive the shares as compensation for services performed. 3. The stock must be issued by a "small-business corporation." For this purpose, a small-business corporation is defined as a corporation with capital of $1 million or less. 4. The corporation must be an actual operating company. During the past five years, the corporation must have received less than 50% of its gross receipts from rents, royalties, dividends and other investment income. If the corporation is less than five years old, this test applies to those years it has been in existence. Note that Section 1244 may be applied to both common and preferred shares of stock. Furthermore, this tax protection is not limited to investments in C corporations. An S corporation may issue Section 1244 stock if it qualifies under the tax rules. Final words: Do not confuse this form of tax protection with other tax breaks for "qualified small business stock" (QSBS). For QSBS acquired during certain time periods, an investor who sells the stock may exclude a portion of the gain, or all of the gain in some cases, from tax. Obtain more details regarding sale of QSBS.