The purpose of this brief note is to examine the provisions of section 1244 with a view toward qualifying for the tax benefits of that section

Davis, Carle E.

English

University of Richmond

University of Richmond Law ReviewVolume 1 | Issue 3 Article 51960The Issuance of Stock Under Section 1244 of theInternal Revenue CodeCarle E. DavisUniversity of RichmondFollow this and additional works at: http://scholarship.richmond.edu/lawreviewPart of the Taxation-Federal Commons, and the Tax Law CommonsThis Article is brought to you for free and open access by UR Scholarship Repository. It has been accepted for inclusion in University of Richmond LawReview by an authorized administrator of UR Scholarship Repository. For more information, please contact scholarshiprepository@richmond.edu.Recommended CitationCarle E. Davis, The Issuance of Stock Under Section 1244 of the Internal Revenue Code, 1 U. Rich. L. Rev. 203 (1960).Available at: http://scholarship.richmond.edu/lawreview/vol1/iss3/5The Issuance of Stock Under Section 1244of the Internal Revenue CodeCARLE E. DAvisPrior to June 30, 1958, the loss on sale, liquidation or worth-lessness of capital stock always resulted in a capital loss tothe non-dealer individual stockholder. The limitations placedon the deductibility of a capital loss often operated to deny atax deduction for a portion of such loss. On the other hand,proprietors and partners were usually permitted to deduct,as ordinary losses and without limitation, losses of capitalinvested in their businesses. In 1958, Congress, concernedwith a somewhat sagging business economy, enacted the"Small Business Tax Revision Act of 1958". The Act createda new section, section 1244, and made substantial changes infour other sections of the Internal Revenue Code. The an-nounced purposes of section 1244 were "to encourage the flowof new funds into small business" and to place the stock-holders in small corporations (with respect to losses) "on amore nearly equal basis with.., proprietors and partners".Unfortunately, the intended tax relief provided by section1244 is not granted to the stockholder automatically and with-out limitation The purpose of this brief note is to examinethe provisions of section 1244 with a view toward qualifyingfor the tax benefits of that section.Section 1244 deals specifically with the tax treatment ofcertain losses arising from the sale, liquidation, or worthless-ness of common stock in a small business corporation. Thesection operates, within limitations, to convert what wouldotherwise be a capital loss into an ordinary loss. The conver-sion of the loss occurs only if (i) there is a qualifying stock-holder who sustains a loss (ii) upon qualifying stock in (iii)a qualifying corporation.Qualifying StockholderThe qualifying stockholder must be an individual and he203204 UNIVERSITY OF RICHMOND LAW NOTESmust be an original stockholder. A corporation, trust, orestate is not a qualifying stockholder. A partner is a qualify-ing stockholder, if he was a partner in the partnership at thetime the stock was acquired by the partnership from the cor-poration upon original issue, and if his distributive share ofpartnership loses reflects the stock loss. However, the part-ner who acquires stock as a distribution from his partnershipis not a qualifying stockholder. There appears to be littlejustification for excluding the stockholder who acquires stockby purchase from another stockholder, or from his partner-ship, or by gift, inheritance, or other transfer, but such is theresult.Qualifying CorporationThe qualifying corporation must be a "small businesscorporation". Such corporation is defined in terms of itscapital structure. Restrictions are placed on the aggregateamount received by the corporation for its stock, or as cap-ital or surplus contributions, and on the amount of equitycapital of the corporation. First, the corporation may notreceive an aggregate amount of money or other property inexcess of $500,000 after June 30, 1958, for its stock, as a con-tribution to capital, and as paid-in surplus. Secondly, theequity capital of the corporation cannot exceed $1,000,000.In determining the amount of property other than cash re-ceived by the corporation for its stock or as a capital contri-bution, the property is taken into account at its adjusted basisto the corporation (for determining gain) as of the date itwas received by the corporation less any liabilities to whichthe property was subject or any liabilities assumed by thecorporation at such time. For example, if Corporation -X, anewly-formed corporation, receives real estate from Y, anindividual, in exchange for all of its capital stock, and the realestate has an adjusted basis of $550,000 in the hands of Y,and a fair market value of $750,000, and the real estate issubject to a deed of trust note of $50,000, the aggregateamount of property received is $500,000 ($550,000, adjustedbasis, minus, $50,000, liability).THE ISSUANCE OF STOCK UNDER SECTION 1244 205The total amount of money or other property received forstock or as a contribution to capital is not reduced by capitaldistributions or by redemptions and retirement of stock ofthe corporation.If the corporation proposes to issue capital stock for cashand other property in excess of $500,000, consideration shouldbe given to the issuance of debt obligations, bonds or short orlong term notes, in lieu of stock. For example, if the corpora-tion requires capital of $750,000 to finance its operations andissues stock for such amount, it will not qualify as a smallbusiness corporation. On the other hand, if the corporationissues stock of $500,000 and its bonds or notes for $250,000, itwould qualify as a small business corporation since the pay-ments for bonds or notes do not represent sums received forstock or as contributions to capital. It is unlikely that theCommissioner would attack the arrangement as constitutinga "thin capitalization".In addition to the restriction upon issuance of stock formoney or other property in excess of $500,000, the aggregatedollar amount of stock which may be offered plus the equitycapital of the corporation cannot exceed $1,000,000. For thepurpose of the restriction, the term "equity capital" meansthe sum of money and other property (in an amount equal toits adjusted basis for determining gain) of the corporation,less the amount of indebtedness to persons other than stock-holders. Equity capital would usually be the sum of the bookvalue of the corporation and the aggregate of loans payableto stockholders. However, the term "indebtedness to stock-holders" will probably be construed to include unpaid sal-aries, bonuses, interest, expenses, and dividends payable tostockholders.Although it has been suggested in this note that consider-ation should be given to the issuance of bonds or notes in lieuof stock when capital in excess of $500,000 is required, in themore usual situation careful consideration should be given tothe problem of whether any debt obligations to stockholderswill be issued. Taxpayers are usually aware of the tax ad-206 UNIVERSITY OF RICHMOND LAW NOTESvantages which accrue to the organizers of corporations ifthey become creditors as well as stockholders of the corpora-tion. Since interest is deductible while dividends are not,there is an obvious tax incentive to having a corporation issueevidences of indebtedness as well as stock for the cash orproperty transferred to it by its stockholders. Moreover, ifthe corporation prospers, it may pay off its debt to its cred-itor-stockholders and, except to the extent that such paymentsexceed the adjusted basis of the debt instrument, the stock-holder will realize no income. To obtain these advantages itwas usually considered desirable to have the corporationissue stock and evidences of debt in exchange for cash andproperty. Care was exercised in making the determinationof the amount of stock and debt to be issued to avoid or mini-mize the challenge by the Commissioner that the corporationwas "thinly" capitalized. Even so, many taxpayers have beenunsuccessful in their efforts and the Commissioner and thecourts have determined that the alleged "loan" should betreated as a disguised capital investment. In the event thecorporation was unsuccessful and unable to pay its debts toits stockholders, the loss arising from the debt was usuallytreated as a short-term capital loss. Section 1244 operates togive an ordinary loss only for loss on stock; the loss on thestockholders' loan remains a capital loss. In view of thefavored treatment afforded losses upon stock issued undersection 1244 over that of stockholders' debt, it might be pref-erable to issue stock for all capital supplied to the corpora-tion thereby avoiding entirely the "thin" incorporation prob-lems. Especially would this be true in those situations wherethe arrangement might fairly be subject to challenge by theCommissioner. The writer is not particularly enchanted withlaws which place a premium on tax planning designed for thepurpose of making one type of loss more desirable thananother type. Unfortunately, however, section 1244 requiressuch planning.In addition to being a "small business corporation", thecorporation, when the loss was sustained, must not have hadTHE ISSUANCE OF STOCK UNDER SECTION 1244 207certain investment or so-called "personal holding companyincome." The rule is that for the five completed taxable yearsprior to the loss, more than 50 per cent of the corporation'saggregate gross receipts must be from sources other thanroyalties, rents, dividends, interest, annuities, and sales or ex-changes of stock or securities. In other words, more than 50per cent of its gross receipts must be from active trade orbusiness sources. If the corporation has not' been in existencefor five taxable years prior to the loss, the 50 per cent testapplies to the period for the taxable year prior to the lossduring which the corporation was in existence; and if the lossis sustained during the first taxable year of the corporationsuch test applies for the period of its existence. However, itshould be noted that the 50 per cent gross receipts limitationis not applicable to a corporation whose deductions over thespecified period exceeded its gross income.Qualifying StockThe qualifying stock must be common stock in a domesticcorporation. The common stock may be voting or nonvotingstock. The corporation may have preferred stock but only thecommon will qualify. The common stock may not be convert-ible into other securities of the corporation. Securities con-vertible into common stock are not treated as common stock.The stock must be issued to the stockholder for money orother property. Stock issued in exchange for stock or secur-ities is not considered as being issued for property. However,if stock is issued in exchange for stock or securities pursuantto a recapitalization or in connection with a change in iden-tity, form, or place of organization of the corporation, thestock will qualify. Common stock issued as a dividend uponqualifying stock is treated as qualifying stock. Stock issuedfor services rendered or to be rendered is not qualifying stock.The stock must have been issued under a plan adopted afterJune 30, 1958, to offer such stock for a period specified in theplan and ending not later than two years after the plan wasadopted. Although section 1244 does not specifically provide208 UNIVERSITY OF RICHMOND LAW NOTESthat the plan should be in writing, the proposed regulationsstate that the plan must be a written plan. Letters to stock-holders and financial plans filed with stock statements maysuffice as a writing but care must be taken to prescribe theperiod for which such stock must be issued. The proposed reg-ulations provide that the requirements for the period will bemet if the period is based upon the date when, under the rulesor regulations of a Government agency relating to the is-suance of the stock, the stock may lawfully be sold, and it isclear that such period will end, and in fact does end, withintwo years after the plan is adopted. Presumably, if stock isissued within the two-year period and pursuant to a stockstatement duly filed with the State Corporation Commission,the requirements of the plan would be met.The corporation may adopt as many plans as desired andeach plan may qualify for the benefits of section 1244. Thecorporation may not, however, have two plans in existenceat the same time. At the time of the adoption of a plan, aprior offering of stock may not be outstanding as to any of theshares offered thereby and then unsubscribed. If any portionof an offering of common or preferred stock is outstandingat the time of adoption of the plan, stock issued under eitherplan will not qualify. Any plan adopted should provide thatoffering under the plan, if not otherwise terminated by theexpiration of a stated period of time, should terminate whenthe corporation shall make a subsequent offering of any stock.The proposed regulations provide that the mere authoriza-tion in the articles of incorporation to issue stock in excess ofstock offered under the plan is not considered a prior offer-ing.Stock may qualify although it is subscribed for prior tothe adoption of the plan, or even prior to the date the corpor-ation comes into existence, provided the stock is not in factissued prior to the adoption of the plan.It is to be expected that the Commissioner will attach greatsignificance to the existence of a written plan. To avoid diffi-culties with the examining revenue agent, the plan should beTHE ISSUANCE OF STOCK UNDER SECTION 1244 209formally adopted by the board of directors of the corporation.The plan should be complete and should specify the periodof the offering (which cannot exceed two years). The minutesof the meeting of the board of directors at which the plan isadopted, or the plan itself, should recite that the stock is be-ing offered to qualify it under section 1244. A balance sheetshowing the equity capital of the corporation before and afterthe issuance of the proposal should be attached to the min-utes. The proposed regulations provide that the plan mustspecifically state, in terms of dollars, the maximum amountto be received by the corporation in consideration for thestock to be issued under the plan. Section 1244 does not re-quire specifically that the plan set forth the maximum dollaramount to be received. It provides only that the amount can-not exceed the limits of an offering of $500,000 and equitycapital of $1,000,000.The adoption by the board of directors of a corporation ofa resolution as follows would appear to meet the requirementsof a plan:RESOLVED, that a plan for the issue of 250 sharesof common stock, par value $100 a share, of this Corpora-tion is hereby adopted, under which this Corporation willoffer for sale 250 shares of such common stock at a priceof $100 a share, the maximum amount to be received bythis Corporation for such shares being $25,000, suchoffer to expire at 3 o'clock in the afternoon on the 60thcalendar day following the date of this meeting, or atsuch date when this Corporation shall make a subsequentoffering of any stock, whichever shall occur sooner.The proposed regulations provide that the plan must ap-pear upon the records of the corporation. In addition, in orderto substantiate an ordinary loss deduction claimed by itsstockholders, the corporation should maintain records show-ing the following:(1) The persons to whom stock was issued pursuantto the plan, the date of issuance to each, and a description210 UNIVERSITY OF RICHMOND LAW NOTESof the amount and type of consideration received fromeach;(2) If the consideration received is property, thebasis in the hands of the shareholder and the fair marketvalue of such property when received by the corporation;(3) Which certificates represent stock issued pur-suant to the plan;(4) The amount of money and the basis in the handsof the corporation of other property received after June30, 1958, and before the adoption of the plan for its stock,as a contribution to capital, and as paid-in surplus;(5) The equity capital of the corporation on the dateof adoption of the plan; and(6) Information relating to any tax-free stock divi-dend made with respect to stock issued pursuant to theplan and any reorganization in which stock is trans-ferred by the corporation in exchange for stock issuedpursuant to the plan.The proposed regulations also require the stockholdersclaiming an ordinary deduction to file with his tax return astatement setting forth:(1) The address of the corporation that issued thestock;(2) The manner in which the stock was acquired bysuch person and the nature and amount of the considera-tion paid; and(3) If the stock was acquired in a non-taxable trans-action in exchange for property other than money-thetype of property, its fair market value on the date oftransfer to the corporation, and its adjusted basis onsuch date.Limitation of LossSection 1244 provides a loss limitation of $50,000 per annumin the case of husband and wife filing a joint return, and$25,000 per annum for unmarried taxpayers. The excess ofloss, if any, over the limitation is treated as a capital loss. Forexample, if A, an unmarried individual, sustains a loss uponstock qualifying under section 1244 in the amount of $40,000,THE ISSUANCE OF STOCK UNDER SECTION 1244 211'25,000 of the loss is deductible as an ordinary loss and theialance, $15,000, is treated as a capital loss.The section 1244 loss qualifies as a net operating loss, sohat a loss up to the limitation may be carried backward andorward under the rules relating to net operating loss deduc-ions.

The Issuance of Stock Under Section 1244 of the Internal Revenue Code

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The Issuance of Stock Under Section 1244 of the Internal Revenue Code

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