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Tax Breaks for Gains and Losses on Small Business Corporations

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Sales of stock in a small business corporation can be treated in a number of ways. To help you keep the most profit (or best mitigate a loss), here are some of the more common scenarios…

Sale of stock at a gain. Gains on sales or dispositions of stock in a corporation are taxed as capital gains provided that the stock was held more than one year. Capital gains are taxed at rates lower than ordinary income, and for people with adjusted gross income (AGI) that places them below the third tax bracket, there is zero tax on long-term capital gains. For 2018, this exempts individuals with AGIs up to $38,700 and married people filing jointly up to $77,400.

Sale of stock at a loss. Losses can be claimed as a capital loss and can offset capital gains with any excess losses deductible in later years with a limit of net capital losses of $3,000 per year. Losses that are not deducted are carried forward and are combined with the next year’s transactions to determine the net effect and if it is a loss, then up to $3,000 per year can be deducted, and the process continues. The $3,000 is reduced to $1,500 for a married person filing separately. Losses retain their character as short-term and long-term, but any excesses are netted regardless of the nature of the gains.

Losses claimed on a joint return. These are deductible as long as the couple remains married. If they are no longer married, the spouse who incurred an unused loss will retain it to use on his/her return. If the spouse with the loss dies, the loss can no longer be carried forward and is forfeited for tax purposes.

Note: Some states do not allow capital loss deductions that are carried forward, so check your state’s rules beforehand when planning your strategy.

Worthless stock. This is deductible only in the year that the company became worthless. So if you have stock in a worthless company, make sure you claim the deduction promptly. If the corporation ceased operations but is still alive, a strategy to consider would be to sell the stock for a nominal amount to record the transaction. 

Section 1244 stock losses. Shareholders who incur a loss on stock that qualifies under Internal Revenue Code Section 1244 can claim an ordinary loss deduction up to $50,000 on a single return and $100,000 on a joint return. To be qualified as Section 1244 stock, the corporation’s aggregate capital must not have exceeded $1 million when the stock was issued; the corporation must not derive more than 50% of its income from passive sources; the stock must have been purchased for money or other property and not issued for services or compensation; and the stock must have been acquired directly from the corporation. This loss is also available to S corporations. There are many technical rules, so it is advisable to consult with a tax expert prior to organizing a new corporation or going forward anticipating such a deduction. Losses over the Section 1244 allowable amounts are treated as capital losses.

Section 1202 qualified small business gains. All or a portion of the gains on qualified small business stock are tax-free provided the requirements of IRC Section 1202 are met. These require that the stock must be owned in a domestic C corporation. The maximum amount of corporate assets at the time the stock was issued (and immediately afterward) cannot exceed $50 million; the stock must have been acquired at its original issue; and during the period of stock ownership, at least 80% of the value of the corporation’s assets must be employed in the active conduct of a qualified business. (See the Code section for definitions of a qualified business.)

There are even more rules here, including that the stock when disposed of must have been held at least five years, and there are maximum gains in any one investment that are eligible for this benefit.

This is a great benefit with many more technical rules that must be adhered to.        As always, check first with your tax adviser. These rules apply to federal taxation and not to state tax treatment. Each state has its own rules that need to be examined.

Documentation. For full tax compliance and especially when there are special benefits, it is essential that you are able to fully document your purchases and the corporation’s qualifications.

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