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Paperwork Requirements for Section 1244 Shares


If you’re just joining us, the first two parts in this series provided plain-language discussions of the Section 1244 rules that can ease the pain when small businesses hit the skids and what happens when shares that satisfied the 1244 requirements are sold or the shares proved to be worthless. This article, part three, will focus on paperwork requirements and preempting audits. 

Section 1244 allows joint filers to claim ordinary-loss write-offs of up to $100,000 ($50,000 for single filers and married couples who submit separate returns) as offsets against ordinary income. Those $100,000 and $50,000 amounts are set by statue; they aren’t subject to annual adjustments to reflect intervening inflation, as discussed previously.

When the unexpected happens. Let’s suppose a client’s investment in a new furniture company pans out, and she sells her 1244 shares for a nifty gain. Assume she has capital losses from sales of other business or personal investments; she can use them to offset gain from a sale of 1244 stock. Otherwise, her 1244 gain is taxed at the preferential rates for capital gains.

Paperwork. There’s no burdensome paperwork to fill out for a corporation that wants to ensure 1244 treatment for its shareholders. The IRS does not require a company to file any specific notification with the IRS, or even adopt any kind of formal plan. An investor should simply make sure that the company specifically designates in its records that all of her stock is qualified 1244 stock.

The IRS does require a company to make the designation in a timely manner. The deadline for the designation is the 15th day of the third month following the end of the corporation’s tax year––by March 15, for example, if the company operates as a calendar-year corporation.

A company should be mindful of other recordkeeping rules that require it to list the serial numbers of all qualifying share certificates. If there are no serial numbers, the company must use an alternative designation in writing at the time it issues the shares to shareholders.

Preempting an audit. Accountants and their clients using the1244 provision should be aware that an ordinary-loss deduction could raise a red flag for the IRS. If challenged, expect the IRS examiner to insist on substantiation.

The tax agency admonishes investors to “maintain records sufficient to establish” that their stock qualifies under Section 1244. The agency’s regulations no longer require Form 4797 (Sales of Business Property) to be accompanied by an information statement. Nevertheless, filing one might help stave off an audit, especially if the loss is large.

The information statement that the regulations used to require included the following data:

  • The company’s address,
  • The manner in which the client acquired the Section 1244 stock and the nature and amount of the consideration, and
  • If the client acquired the stock in exchange for property other than cash, the type of property, the fair market value on the date of transfer to the corporation and its adjusted basis on that date.

As for the corporation, it should keep records that show:

  • The individual to whom the 1244 stock was issued,
  • Dates of issue,
  • Amount of money (and corporation’s basis in property other than cash) received for stock, as contributions to capital and as paid-in surplus, and
  • Company financial statements for the last five years.

To be on the safe side, clients should ask the company to ensure it will keep the required records and provide the client with access to those records when needed to claim any losses on the stock. Armed with the proper documentation, clients should be able to keep the IRS at bay.

What’s next. Part four will discuss what requirements corporations have to satisfy to qualify under Section 1244.

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