Does S Corp Stock Qualify for Section 1244?

When a business fails or stock becomes worthless, investors take losses in the shape of capital losses, which, as we all know,  have limits on how much you can deduct each year on your taxes (generally up to $3,000 per year per person). 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 run them directly through your 1040 form and aggressively reduce your taxable income in the same tax year.

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 when and 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.

Here’s why:

- As an S corporation has losses, those losses go to the shareholders and reduce the basis of their stock.

- So if the stock becomes worthless later, the investor might have no basis left, and there's no loss to claim under Section 1244.

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.

An Example: How Basis Affects the 1244 Loss

Let’s say this happens:

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

- Later, you put in another $2,000 as extra capital contribution, raising your total stock basis to $12,000.

- Then, you sell the stock for $9,000.  $12,000 - $9,000 = $3,000, which is your total loss.

But only the original $10,000 counts for Section 1244. Here’s how the 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.

Even though your basis is $12,000, only $10,000 counts as Section 1244 stock. So, only the part of your loss tied to that $10,000 can be treated as an ordinary loss.

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. Please keep us in mind if you ever need help. You can read about our services here.