Section 1244 Tax Code: Ordinary Loss Rules for Small Business Stock

A Section 1244 stock loss lets an individual investor deduct up to $50,000 ($100,000 on a joint return) of a loss on qualifying small business stock as an ordinary loss rather than a capital loss. That single reclassification is the whole point of the provision: ordinary losses offset wages, self-employment income, and any other earnings dollar for dollar in the year you take them, while capital losses that aren’t matched against capital gains are throttled to just $3,000 a year against ordinary income.¹

The math shows why it matters. Someone who put $80,000 into a failed startup and had no capital gains to absorb the loss would need decades to work it off at $3,000 per year. Under Section 1244, up to $50,000 of that same loss can come off a single year’s salary immediately.²

Does Your Stock Qualify

Every one of these conditions has to be true, and the burden of proving each falls on you when you claim the loss.

Domestic corporation. The issuer must be organized in the United States. Foreign corporation stock never qualifies.²
Issued for money or property. Stock received in exchange for services, other stock, or securities does not qualify.³
Original issuance to you. The shares must have come directly from the corporation. Shares purchased from another shareholder or on a secondary market are out, even if they would have qualified in the original owner’s hands.
Small business corporation at the moment of issuance. That test has two parts, covered below.

One thing you don’t need: a formal corporate plan designating the shares as “Section 1244 stock.” That old requirement was eliminated. If the statutory criteria are met, the stock qualifies automatically, though careful documentation at issuance saves you the headache of proving eligibility years later.

The $1 Million Capitalization Test

At the time your stock is issued, the total money and property the corporation has received for all its stock, plus paid-in capital and capital contributions, cannot exceed $1,000,000.² This is a cumulative measurement across every share the company has ever issued, not just yours. If a company had already raised $900,000 and then issues you $200,000 of stock, the running total is $1.1 million at your issuance, and your shares fail.

The threshold has not been adjusted for inflation, so it is easy for a modestly successful startup to blow past it. Verify the company’s cumulative capital receipts before you wire the money if Section 1244 protection is part of your calculus.

The Active Business (Gross Receipts) Test

For the five tax years before the loss, more than 50% of the corporation’s total gross receipts must have come from active operations rather than passive sources like dividends, interest, rents, royalties, annuities, or gains from selling stocks and securities.² If the company has been around less than five years, the test applies to its full lifespan.

A pre-revenue company that failed before earning anything still qualifies, because there are no receipts to fail the test. That quirk makes Section 1244 especially useful for the earliest-stage investments, where total loss is most likely.

Who Can Claim the Ordinary Loss

Only individuals. The statute allows the treatment for stock issued to an individual directly or to a partnership where the individual is a partner, in which case the loss flows through on the partner’s personal return.²

Corporations, trusts, and estates are shut out no matter how they acquired the stock. So are S corporation shareholders. The regulations limit the benefit to individuals and partners in partnerships, and the Tax Court has held that S corporation shareholders cannot claim Section 1244 treatment on stock the S corporation holds.³ If you route a small-business investment through an LLC taxed as a corporation, a family trust, or a holding company for liability or estate reasons, you lose the deduction entirely.

The Annual Cap and What Happens Above It

The ordinary loss deduction tops out at $50,000 per year for single filers and $100,000 for married couples filing jointly. Married filing separately caps each spouse at $50,000. The limit applies to your total Section 1244 losses for the year across every qualifying investment, not per company.²

Anything above the cap doesn’t vanish. It reverts to capital loss treatment, deductible against capital gains without limit and against ordinary income at the usual $3,000 per year, with the balance carried forward.¹

If your loss is bigger than the annual cap, timing matters. A single filer disposing of $80,000 of losing stock in one year gets $50,000 as ordinary and $30,000 as capital. Selling $50,000 in each of two consecutive years keeps the full $100,000 within ordinary treatment. No formal election is needed. You take ordinary treatment on the qualifying portion in whichever year the stock is disposed of.⁴

The Net Operating Loss Bonus

Section 1244 losses are treated as attributable to a trade or business for net operating loss purposes.² Without that rule, an individual’s investment loss would count as a nonbusiness deduction that could only offset nonbusiness income when computing an NOL. With it, a Section 1244 loss large enough to exceed your income for the year can generate an NOL you carry forward to future years, which is particularly useful when your income is mostly wages.

How to Report the Loss

Report the loss on Form 4797, Sales of Business Property, on line 10 of Part II. Write “Losses on Section 1244 (Small Business Stock)” in column (a) and the allowable ordinary loss amount in column (g), and attach a computation showing how you arrived at the number.⁴ The ordinary loss then flows to Schedule 1 of Form 1040 and reduces your adjusted gross income.⁵ Any excess over the annual cap goes on Schedule D as a capital loss, not on Form 4797.

The loss is triggered when you sell the stock, exchange it in a taxable transaction, or when the stock becomes completely worthless. Worthlessness counts as a deemed sale, though pinning down the exact year worthlessness occurred can be contentious. A formal dissolution or bankruptcy in which shareholders receive nothing typically establishes the year of loss.

Records You Need to Keep

The IRS challenges Section 1244 claims, and you carry the burden of proof on every element, not just the dollar amount. Gather and hold onto:

Stock certificates, subscription agreements, or corporate minutes showing the shares were issued directly to you for cash or property.
Corporate records of total money and property received for all stock as of your issuance date, proving the $1 million cap wasn’t crossed.
The corporation’s tax returns or financial statements for the five years before the loss, showing the active-business majority in gross receipts.
Documentation of your basis, meaning what you paid or the fair market value of property contributed, plus any adjustments.

Keep the file at least three years after filing the return that claims the loss.⁶ Longer is smarter. If capital-loss carryovers from the same transaction spill into future years, the IRS can question the underlying deal when it examines a later return, and founders often lose track of corporate formation records after a company folds. Pull copies while the company still exists.

1
Internal Revenue Service. Topic No. 409, Capital Gains and Losses
2
Office of the Law Revision Counsel. 26 USC 1244 – Losses on Small Business Stock
3
eCFR. 26 CFR 1.1244(c)-1 – Section 1244 Stock Defined
4
Internal Revenue Service. Instructions for Form 4797
5
Internal Revenue Service. Form 4797 – Sales of Business Property
6
Internal Revenue Service. How Long Should I Keep Records?