This week’s blog focuses on a loophole to the $3,000 deduction on capital loss losses. Businesses don’t always go as people hope they will. Unfortunately, in the last year we’ve seen a lot of struggle. Many businesses in specific industries, including food and entertainment, have had to close their doors. For business owners and entrepreneurs, that can often mean significant losses.
A business is a capital asset. When you sell that asset for profit, that’s a capital gain. When you sell at a loss or close it down, that is a capital loss. But, unfortunately, capital losses are limited to $3,000 per year, or $1,500 if married and filing a separate return.
Of course, when a business goes under, most investors lose a lot more than $3,000.
Anyone in this situation should be aware of the Section 1244 small business stock loophole. If you’re selling qualified 1244 stock at a loss (we’ll define what that means in a moment), you can treat up to $100,000 (if you’re a joint filer, or $50,000 if you’re not) as an ordinary loss, rather than as as a capital loss.
Here is one more example of the importance of a good entity analysis, because the 1244 rule does not apply to LLC’s. (Of course, the owners of the LLC may not need 1244, provided that they have sufficient basis in that business loss to be able to deduct it.) But you can see, once again, how critical the entity determination can be. It can be the difference between a limited loss of just $3,000 per year, versus being able to deduct up to $100,000 in losses.
There are three criteria to qualify as Section 1244 stock:
- The corporation’s equity must not exceed $1,000,000
- The stock must be issued for money or property
- For five years preceding the loss, more than half of the business’ revenue must be from business operations and not passive income
The 1244 loophole is a viable strategy, regardless of holding periods. If unlucky entrepreneurs opened a restaurant in February of 2020 and closed two months later, they’ve got an opportunity to take that 1244 loss.
You can use 1244 to offset any other income that you have. If you’re in the 37% tax bracket, that 1244 loss may effectively save you 37% times the amount of the loss. Of course, it’s not always cut and dry. You could be in the 37% tax bracket, but just a dollar over the threshold. As accountants, we must calculate the client’s effective tax rate and multiply that effective tax rate against the amount of that loss so that they can take that deduction.
Lastly, while we keep using the term “loss”, you are obviously not actually selling an entity when you go out of business. You’re simply liquidating or disposing of it in some way. When you dispose of a business at a loss and shut it down, that is precisely where 1244 applies.
In summary, this is an example of converting capital losses to ordinary income. Of course, there are also times when you would want to go in the other direction.
If you’re interested in learning how to bring these and other tax saving strategies to your clients, click here to find out how to become a Certified Tax Planner.