Whether you know it or not, a single decision made at the time of your company's incorporation can have significant tax implications farther down the road.
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It's called a 1244 election, and it could make a big difference in the amount of money you keep and the amount you turn over to Uncle Sam.
The decision to make a 1244 election happens at the first board meeting of a newly formed corporation. This election is only open to S- and C-corporations, but it gives you the ability to deduct ordinary losses against capital gains. Since the profits from these types of corporations are passed along to and reportable by individual shareholders, you have a lot to potentially gain from Section 1244. But before you get too excited, you need to know what a 1244 election entails.
Overview of Section 1244 Elections
The IRS Code typically permits incorporated entities to only deduct ordinary losses from ordinary gains, and capital losses from capital gains. If you made a nice profit last year, but took a big loss from the sale of an asset you ordinarily wouldn't be able to offset your ordinary taxable income with your capital loss. With certain limitations, Section 1244 election would allow you to offset part or all of your ordinary income with your capital loss, thus significantly reducing your taxable income.
Restrictions on Section 1244 Elections
As you probably guessed, Section 1244 elections entail a number of restrictions and limitations imposed by the IRS. For starters, 1244 benefits only apply to the original owners of the corporation. If the stock is sold to someone else, the new owner is not eligible under the 1244 program. Additionally, the stock must be common stock issued by a domestic corporation in exchange for cash or property not exceeding an initial value of $1 million.
But even if you jump through all of those hoops, there is at least one more test you still need to pass to qualify for 1244 benefits. It's called the Gross Receipts Test and here's how it works. The amount of income the corporation generates isn't as much of a concern to the IRS as the way you generated it. If 50% or more of your corporation's income was derived from "prohibited" sources (i.e. rents, royalties, interest, dividends, stock sales, etc.) for the last five years, then you will probably not be allowed to take advantage of 1244.
Deduction Limitations for Section 1244 Elections
If you qualify for a 1244 deduction, the annual amount you will be able to deduct is $50,000 or $100,000 if you are married and file a joint return. If the business or your stock is liquidated, you should be able to deduct the full amount of your loss against the ordinary income you are required to report.
Determining eligibility and deductibility of 1244 exemptions can be a complicated process. Unless you are either an adrenalin junkie or a corporate accountant, your best course of action is to consult a professional tax preparer with a background in corporate taxation before claiming a 1244 deduction.