Section 1244 Stock

Section 1244 stock is stock of a qualifying U.S. domestic small-business corporation that can give an eligible original individual shareholder ordinary-loss treatment when the shares are sold, exchanged, or become worthless. The rule changes the character of a qualifying loss; it does not exclude gains, guarantee a deduction, or certify that the company is a good investment.

An ordinary loss can be more immediately usable than a capital loss, but Section 1244 applies only when the corporation, issuance, shareholder, business activity, basis, and documentation requirements are satisfied.

Key Takeaways

• The corporation must be domestic and meet the statutory small-business capital test when the stock is issued.
• The shareholder generally must acquire the stock at original issuance for money or eligible property, not buy it from another shareholder.
• The corporation must satisfy an active-business gross-receipts test for the applicable period, unless a statutory exception applies.
• Individuals can claim no more than $50,000 of Section 1244 ordinary loss per tax year, or $100,000 on a joint return.
• Loss above the annual ordinary-loss limit generally remains capital loss.
• A gain on the stock remains capital gain when the shares are capital assets in the investor’s hands.
• Records must trace which shares qualify, the original consideration, later basis changes, and the loss event.

What Section 1244 Changes

Stock is generally a capital asset for an investor. Without a special rule, loss on a sale or worthlessness is generally capital, subject to the capital-loss netting and deduction rules. Section 1244 allows part or all of an eligible loss to be treated as ordinary instead.

Section 1244 is asymmetric: it can change loss character without turning gain into ordinary income. Gains cannot be netted against qualifying Section 1244 losses to reduce the amount tested under the ordinary-loss limit.

Corporation Requirements

Domestic Small-Business Corporation

The issuer must be a domestic corporation. At the time the relevant stock is issued, the aggregate amount of money and other property received by the corporation for stock under the Section 1244 capital computation generally cannot exceed $1 million.

This is not a test of the company’s current enterprise value, revenue, or total assets. It is a statutory capital-receipts test applied when shares are issued. If an issuance occurs after the corporation exceeds the limit, or an issuance spans the limit, detailed allocation rules can affect which shares qualify.

Eligible Consideration

The stock must be issued for money or property other than stock or securities. Buying existing shares from a founder, employee, or other investor does not satisfy the original-issuance requirement, even if the company otherwise qualifies.

Stock issued after July 18, 1984, may be common or preferred stock. Debt, options, and other instruments should not be assumed to qualify merely because they finance a small corporation.

Active-Business Gross-Receipts Test

For the applicable testing period before the loss, the corporation generally must derive more than 50% of its aggregate gross receipts from sources other than royalties, rents, dividends, interest, annuities, and gains from stock or securities transactions.

The testing period generally covers the five most recent tax years ending before the loss. Shorter rules apply if the corporation existed for fewer than five years. IRS Publication 550 also describes an exception when specified deductions exceed gross income during the period.

The test is evidence-based. A company description or industry code alone does not establish the composition of gross receipts.

Shareholder Requirements

The ordinary-loss benefit generally belongs to an individual who received the stock at original issuance. A buyer who later acquires the shares on a secondary market normally cannot inherit Section 1244 status.

A partnership can hold Section 1244 stock, but that does not make the partnership itself an individual claimant. A partner may receive a share of qualifying loss only under the pass-through rules, including the requirement that the person was a partner when the partnership acquired the stock and remained a partner continuously until the loss. Stock later distributed by the partnership to a partner does not retain ordinary-loss treatment for a subsequent loss in that partner’s hands.

Corporations, estates, and trusts do not receive the individual Section 1244 ordinary-loss treatment merely because they own qualifying-company shares.

Annual Ordinary-Loss Limit

The maximum Section 1244 loss treated as ordinary in one tax year is:

• $50,000 for an individual return other than married filing jointly
• $100,000 for a married couple filing jointly, even if only one spouse owns the qualifying stock

The limit applies across the taxpayer’s Section 1244 losses for the year, not separately to each corporation or block of shares. The remaining eligible loss is generally capital.

Worked Example

Assume an individual invested $80,000 in newly issued shares, has an $80,000 adjusted loss basis attributable to qualifying Section 1244 stock, and the shares become wholly worthless. Assume all corporate, issuance, activity, ownership, and substantiation tests are met.

For the single filer, the calculation is:

1Total qualifying loss                       $80,000
2Maximum Section 1244 ordinary loss         (50,000)
3Remaining capital loss                      $30,000

The capital portion then enters the normal capital-gain and capital-loss netting process. The example does not establish whether the stock is worthless in a particular year or whether another tax limitation applies.

Basis Can Limit the Ordinary Portion

Cost basis for Section 1244 purposes can differ from the basis used to compute total loss.

• If stock was issued for property whose adjusted basis exceeded its fair market value, the excess basis is excluded when determining the ordinary-loss portion.
• A later contribution to capital or another post-issuance basis increase is generally treated as basis in non-Section 1244 stock when the ordinary loss is computed.
• If a shareholder owns both qualifying and nonqualifying shares of the same issuer, records must identify the relevant lots and allocate basis correctly.

These rules prevent an investor from converting pre-existing property loss or later capital contributions into Section 1244 ordinary loss.

Sale, Exchange, or Worthlessness

Section 1244 can apply when qualifying stock is sold, exchanged, or becomes worthless. A low valuation, insolvency, discontinued operations, or failed fundraising does not by itself prove complete worthlessness in a particular year.

The taxpayer should document identifiable events, residual value, creditor priority, liquidation status, attempts to sell, and the date the shares lost all value. If the shares retain any value, an abandonment or sale may follow different rules. Timing matters because a worthless-security loss generally belongs in the year worthlessness becomes complete.

A holding period does not replace the Section 1244 eligibility tests. The ordinary portion is not obtained merely by holding qualifying-company stock for a minimum number of months or years.

Reporting the Loss

IRS guidance directs individuals to report the allowable ordinary Section 1244 loss on Form 4797 and to report loss above the ordinary-loss limit through the capital-gain and loss forms. Gains are also reported under the capital rules when the stock is a capital asset.

The Form 4797 instructions require a computation of the Section 1244 loss. Check the form and line instructions for the filing year rather than relying on an old line number.

Maintain records showing:

• the issuer’s legal name and domestic status
• board, subscription, and stock-issuance documents
• issue date, share class, number of shares, and consideration paid
• the corporation’s Section 1244 capital computation at issuance
• evidence supporting the active-business gross-receipts test
• the shareholder’s original-owner status
• lot-by-lot basis and later capital contributions
• sale, exchange, liquidation, or worthlessness evidence
• any partnership ownership history and loss allocation

Calling shares “Section 1244 stock” in a certificate or capitalization table is helpful documentation but does not cure a failed statutory test.

Section 1244 vs. Qualified Small Business Stock

Section 1244 and Section 1202 are separate regimes that can both involve small-business shares.

Do not assume that stock qualifying under one section qualifies under the other. Each provision has its own issuer, issuance, activity, ownership, and timing rules.

Review Checklist

1. Confirm that an individual is claiming the ordinary loss.
2. Verify direct acquisition at original issuance or a qualifying partnership path.
3. Confirm that the issuer was a domestic corporation.
4. Reconstruct the corporation’s Section 1244 capital test at the issue date.
5. Verify that the stock was issued for eligible consideration.
6. Test gross receipts for the applicable active-business period.
7. Reconcile original investment, later basis adjustments, and proceeds.
8. Establish the year and nature of the loss event.
9. Aggregate all Section 1244 losses under the annual limit.
10. Separate the ordinary portion from the capital portion and retain the computation.

Common Mistakes and Limitations

• Treating every startup or small-company share as Section 1244 stock.
• Using current company value instead of the capital test at issuance.
• Claiming ordinary treatment for shares bought from another shareholder.
• Describing a partnership as automatically eligible without tracing each partner’s status.
• Ignoring the active-business gross-receipts test.
• Applying the annual limit separately to each investment.
• Treating a gain as ordinary because a loss would have qualified under Section 1244.
• Including later capital contributions in the qualifying ordinary-loss basis.
• Claiming worthlessness before the shares have lost all value.
• Failing to distinguish Section 1244 shares from other shares of the same corporation.
• Confusing Section 1244 with the different gain-exclusion rules for qualified small business stock.

Authoritative Sources and Use Boundary

IRS Publication 550 explains Section 1244 loss treatment, company and shareholder requirements, basis adjustments, partnership rules, annual limits, and recordkeeping. The Instructions for Form 4797 explain how individuals report the ordinary portion and direct excess loss to the capital-loss process. The statutory text and regulations contain additional rules beyond this overview.

This article provides general U.S. federal tax education, not tax, legal, accounting, valuation, or investment advice. Eligibility and deductibility depend on current law, filing status, issuer records, stock basis, ownership history, business receipts, the loss event, and the taxpayer’s full return.

Related Terms

• Capital Loss: The default character for many investment-stock losses and the treatment for Section 1244 loss above the annual limit.
• Ordinary Income: Income that may be offset by an allowable ordinary loss, subject to the taxpayer’s broader tax position.
• Shareholder: The owner whose acquisition path and tax status affect Section 1244 eligibility.
• Cost Basis: The starting point for measuring loss, subject to Section 1244 adjustments.
• Capital Gains Tax: The broader regime that generally applies to gains and non-ordinary portions of stock loss.

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