The Tax Cuts & Jobs Act of 2017 changed the choice of entity decision quite a bit. It affords corporate taxpayers the benefit of the lower flat 21 percent tax rate. It provides non-corporate businesses a 20% qualified business income deduction. There were other changes too.
This is in addition to the existing tax rules that impact the choice of entity decision. The availability of Section 1202 stock and Section 1244 stock for corporations are examples. Section 1202 allows companies that are sold for a gain to avoid tax. Section 1244 allows companies that are sold for a loss to be treated as ordinary losses. These tax laws also have to be considered when deciding what type of entity should be used.
Section 1244 in particular is often overlooked. That is exactly the case in Ushio v. Commissioner, T.C. Summ. Op. 2021-27. The availability of Section 1244 was not even considered when reporting the tax loss. It was raised as an affirmative adjustment by the taxpayer for the first time on audit by the IRS. This court case is an opportunity to consider Section 1244.
Facts & Procedural Hsitory
This case involved a corporation that the taxpayers purchased for $50,000. The business planned to invest in another entity. The other entity had invested $125,000 in a business venture.
On audit by the IRS, the IRS agent had raised various adjustments to the taxpayer’s tax return. The taxpayer then argued that the stock was worthless and it qualified as Section 1244 stock.
The IRS countered that the taxpayer had not substantiated that the corporation qualified for Section 1244 stock treatment. Tax litigation ensued.
About Section 1244 Stock
A tax loss incurred on the sale of corporate stock is usually capital in nature. This means that the tax loss can only offset capital gains. Absent other capital gains, the tax loss is only allowable to up to $3,000 per year. These rules are found in Section 165(g) for worthless securities.
Section 1244 provides an exception to these rules. Section 1244 provides that a tax loss from worthless corporate stock can count as an ordinary loss. This means that the loss can offset capital and ordinary gain and it can even generate a net operating loss to be carried to other tax years. The amount is capped at $50,000 for single taxpayers and $100,000 for married taxpayers.
Congress enacted Section 1244 to encourage taxpayers to invest in operating businesses rather than investment or holding companies. It’s a benefit for start-up companies. Small business enterprises.
To qualify for Section 1244, the taxpayer has to satisfy several tests:
- The stock had to be issued to an indvidual or partnership.
- The corporation has to be a small business corporation, which is a corporation that received less than $1 million in contributions.
- The stock had to be acquired for cash or property and not for services.
- For the prior five years before the sale, the corporation had to derrive more than 50 percent of its aggregate gross receipts from sources other than royalties, rents, dividends, interests, annuities, and sales or exchanges of stocks or securities.
Section 1244 has been on the books for some time now. Yet there has been very little guidance explaining how these rules apply. There have only been two reported court cases involving Section 1244 stock in the last twenty years (there were quite a few court cases in the 1970-1980s involving stock issued pursuant to a plan, which is a requirement that generally doesn’t apply now). That brings us back to this case.
Substantiating Section 1244 Stock
In the Ushio court case, the court concluded that the taxpayer did not substantiate their Section 1244 stock. This case shows what taxpayers need to document to qualify for Section 1244.
The court focused on the requirements that the corporation is a small business and that 50% of its aggregate gross receipts were not from sources other than royalties, rents, dividends, interests, annuities, and sales or exchanges of stocks or securities.
The record before the court included accounting records that showed that less than $1 million was contributed to the corporation. However, the same records showed that the taxpayer had “deferred pay.” The taxpayer testified that this deferred pay was not actually paid. The court found testimony alone to be insufficient.
With respect to the sources of income, the court did not find that the taxpayers stated intention to engage in a business was sufficient. The taxpayer had an agreement that said he would do so, but there was no evidence that he actually did so.
In other cases, it would seem that these two requirements would be easy to substantiate. The business records and even tax returns should state what the capital contributions were. They would also provide evidence as to the types of income and expenses incurred. This would show that the income was from a trade or business and not an investment.
It is not clear whether the court is imposing a higher substantiation standard for SEction 1244 stock, or if the court record really was devoid of evidence.
Taxpayers taking advantage of the Section 1244 stock rules should document the factors that allow them to qualify. This could include corporate minutes and resolutions, accounting and bank records, and even operational records.
These records can go a long way in ensuring that the loss on the sale or exchange of the stock is treated as an ordinary tax loss, rather than being limited to the minimal $3,000 capital gain offset rules.
These same records and analyses should also be considered when deciding which choice of legal entity to use. This type of advanced tax planning can help ensure that a tax loss on a start-up is allowable sooner rather than later.