Does S Corp Stock Qualify for Section 1244?

When a business fails, the investors take losses as capital losses on their taxes, which, as we all know,  have limits on how much you can deduct each year (generally up to $3,000 per year). But there’s a special tax rule called Section 1244 that lets some investors treat their loss as an ordinary loss instead. Ordinary losses are better for tax purposes since you can directly deduct them against other income on her tax return.

So the big question is: Can S Corporation stock qualify for Section 1244?

Yes — but only in very limited situations. Let’s break down the rules to understand how S Corp stock might qualify.

What Is Section 1244?

Section 1244 is a rule that lets people who invest in small businesses claim a bigger tax break if their investment turns out badly. Instead of being stuck with a capital loss (which has yearly limits), you can claim an ordinary loss of up to:

- $50,000 if you file taxes alone

- $100,000 if you file a joint return with your spouse

But you only get this special treatment if your stock meets all the Section 1244 rules.

What Are the Rules for Section 1244 Stock?

For your stock to qualify, these six conditions must be true:

1. The company must be a U.S. corporation.

2. You must have bought the stock with money or property — not other stock.

3. The company must have raised less than $1 million from selling all its stock.

4. More than half of the company’s income must come from real business activities, not passive income.

5. The amount of the loss can’t be more than $50,000 (or $100,000 on a joint return).

6. If the stock was issued before November 17, 1978, the company had to file a written plan.

How Does This Work With S Corporations?

An S corporation is a type of business that doesn’t pay income taxes itself. Instead, profits and losses 'pass through' to the owners, who report them on their personal tax returns. That 'pass-through' part causes a problem with Section 1244.

Why "pass - through" is not a good thing here?

When an S corporation has losses, those losses pass through to the shareholders’ individual tax returns. When the shareholder uses those losses to reduce their taxes, the S Corp basis is reduced by the amount of the loss claimed.

If the S corporation later fails, the investor may have little or no basis remaining, since it has already been reduced by prior losses. Because Section 1244 allows a deduction based on the investor’s basis, having little or no basis means the investor will have little or no ordinary loss to claim.

This means Section 1244 losses are rare with S corporations, because the stock basis is often already reduced by the time the stock becomes worthless.

Here is an Example of how Basis Affects the 1244 Loss:

Let’s say this happens:

• You buy 100 shares of Section 1244 stock in an S corporation for $10,000.

  
  

• Later, you contribute an additional $2,000 to the corporation as capital, increasing your total basis to $12,000.

  
  

• You then sell the stock for $9,000, resulting in a total loss of $3,000.

  
  

However, only the portion of your basis attributable to stock issued (the original $10,000) is eligible for Section 1244 treatment. The additional $2,000 contribution increases your overall basis but does not qualify for ordinary loss treatment because no stock was issued in exchange.

Here’s how this loss breaks down:

- $2,500 of the loss (10,000 ÷ 12,000 × 3,000) is related to the 1244 stock and can be claimed as an ordinary loss.

- $500 of the loss is related to the extra capital contribution and must be claimed as a capital loss (remember we talked about $3000 per year allowable deduction)

The moral of the story: whenever it is possible, try to get some shares in exchange for the money you put into your corporation. It may come in handy later.

A Special Note About Restoring Basis:

Sometimes, your basis can go back up if the S Corp earns money and passes it through to you. But that doesn’t raise your Section 1244 basis above the original amount.

In other words:

- If you had $10,000 of 1244 stock that dropped to $5,000 because of pass-through losses...

- And then the company made $5,000 in income that raised your basis back up...

- Your Section 1244 basis is still just $10,000 — it can’t increase beyond what you originally paid.

Final Answer: Can S Corp Stock Qualify?

Yes — S Corp stock can qualify for Section 1244 treatment if all the rules are met.

But it's rare because S corporation losses reduce your stock basis over time, and that often means there’s no basis left to claim an ordinary loss when the stock becomes worthless.

Still, if:

- You bought your S Corp stock with money,

- The company met the income and fundraising limits,

- And you still have some stock basis left when you sell or lose the stock....then you may be able to claim an ordinary loss under Section 1244.

Tax Pro Tip:

In the case of a tax audit, the IRS will screen the shareholder personal tax return to see if the ordinary loss appears on Form 4797, Part II, Line 10 and will also look up their basis information. If you claim ordinary losses, be sure the stock meets all the requirements for Section 1244 and that the shareholder still has basis remaining in the stock when it becomes worthless or is sold at a loss. Carefully review how much of the loss qualifies as ordinary and how much as capital.

Citations

- Internal Revenue Code § 1244

- Treasury Regulation § 1.1244(d)-2(a)

- Treasury Regulation § 1.1244(e)-1(a)

And now a shameless plug (since unfortunately nothing in this life is free): We are an accounting firm helping S Corp owners with their taxation and accounting issues. You can read about our services here.