You start a business, work hard, and the business fails anyway. This is nothing to be ashamed of. Succeeding in your own business is a high risk/high reward undertaking. Thankfully, the IRS provides a payback if you start a business and end up failing.
The tax code provides significant tax benefits for someone who has failed in their own business. While failing in business is never good the tax code pays you back for your losses through a little known section of the tax code, section 1244.
Plan to Make the IRS Pay You for Your Business Failure
QUICK TIP. When you set up your small business be sure that you protect your investment in the event of a business failure. Make provisions so in the event of a business failure your company can claim an ordinary loss under section 1244 of the Internal Revenue Code.
Here is an example of our client who benefited from the section 1244 loss
A retired Bloomington, Minnesota couple lost $200,000 of their investment before the business closed. The Tax Resolution Center utilized the 1244 loss to turn their tax bill into a tax refund. They went from owing the IRS $105,000 in taxes to getting a $37,000.00 refund. The wife said that she was able to sleep for the first time in more than 10 years. They got their life back and now they can enjoy their retirement. Without the 1244 tax treatment the seventy-one year old couple would have been limited to claiming a $3,000.00 yearly loss.
Why 1244 Business stock is valuable after a business failure?
Ordinarily, the disposition of stock results in capital gain or loss and no matter how much your capital loss is it can only be deducted at the rate of $3,000 a year. The great thing about a Section 1244 Ordinary loss is it will offset income from any source. For instance a Section 1244 loss will offset capital gains on your stock portfolio, dividends from your mutual fund, interest from your bank, even income from your spouses teaching job. Each year, a single taxpayer can claim up to $50,000 in 1244 losses and a married couple can claim up to $100,000 in 1244 losses. If you have 1244 losses that you cannot use this year you can carry them forward to offset income in future years.
Small Business Designation
No business plans to fail. However it is prudent to take steps to assure that if your business fails then you will be able to claim a Section 1244 Ordinary loss on your next tax return. To be eligible for the Section 1244 Ordinary Loss a business entity should not be capitalized with more than One Millions Dollar of cash and property. If additional capital is contributed then only the first one million dollars invested in shares could be classified as 1244 stock.
Corporations, trusts or estates are not eligible for the 1244 loss. If the 1244 stock was transferred through inheritance, sale, or gift again it is not eligible for the 1244 loss. Finally, a loan to a corporation or partnership does not create stock eligible for the 1244 loss.
Loans to the company do not qualify for 1244 treatment
The 1244 ordinary loss provision applies only to small business stock and partnership interests. Loans to a corporation or to the partnership, unless properly converted to 1244 stock or 1244 partnership interests do not qualify for the favorable 1244 ordinary loss treatment.
The Operating Company Requirement
For the shareholder or partner to claim 1244 losses upon the cessation of business or after the business bankruptcy the small business must have derived more than 50% of its aggregate gross receipts from sources other than rents, royalties, dividends, interest, annuities and sales or exchanges of property. In other words, the company must have had operating income.
The intricacies of claiming a Section 1224 Loss are complicated and not always obvious. Critical in claiming the Section 1244 Ordinary Loss is setting up your company properly.
Call us for a free consultation on how to set up a company eligible for the Section 1224 Ordinary Loss Treatment because a business’s exit strategy is as important as its business plan. If you have already closed your business then consult a tax attorney or CPA with experience in claiming section 1244 losses.