An investment in a young company can become worthless. Section 1244 may allow an eligible individual to deduct part of that loss as an ordinary loss, which can be more useful than a capital loss. The benefit depends on how the stock was issued, the corporation’s financing and receipts, and the evidence supporting the year of loss.

Why the distinction matters

A stock loss is normally a capital loss. After capital gains and losses are netted, an individual may generally use no more than $3,000 of net capital loss against other income in a year, carrying the balance forward. Section 1244 permits up to $50,000 of eligible losses to be treated as ordinary in one tax year, or up to $100,000 on a joint return. The annual limit applies across qualifying losses, even if only one spouse owned the stock. An excess loss generally retains its capital character.

What stock qualifies

• The issuer must be a domestic corporation. At the time of issuance, its aggregate money and property received for stock, capital contributions, and paid-in surplus must generally be no more than $1 million, including the amount received for the shares at issue. Special designation rules can apply when the threshold is crossed.

• The corporation must issue the shares for money or property other than stock or securities. Shares issued for services do not qualify. For shares issued after July 18, 1984, either common or preferred stock may qualify.

• The individual claiming the ordinary loss must generally have acquired the shares at original issuance and held them continuously. Buying shares from another shareholder does not satisfy this rule. A partner may qualify for a share of a partnership’s loss only under specific continuous-partner requirements.

• Generally, more than 50% of the corporation’s aggregate gross receipts during the five most recent tax years before the loss must come from sources other than royalties, rents, dividends, interest, annuities, and securities gains. Shorter operating histories have corresponding testing periods. The test does not apply if specified deductions exceed gross income for that period.

These are the principal tests, not a substitute for reviewing the issuance and capitalization records. A later contribution that increases stock basis may not increase the amount eligible for ordinary-loss treatment. Property contributed with built-in loss can also limit that amount.

When the loss is recognized

A qualifying loss may arise from a sale or exchange or when the stock becomes wholly worthless. A price decline or poor outlook alone does not establish worthlessness. The loss belongs in the tax year supported by the facts; liquidation records, a cessation of operations, insolvency evidence, and other identifiable events can help establish the timing. Partial worthlessness is insufficient.

Example

Suppose an investor filing jointly paid $300,000 in cash for newly issued shares that satisfy every Section 1244 requirement. The shares later become wholly worthless. Assuming no basis adjustments or other limitations, $100,000 may be an ordinary loss and $200,000 a capital loss. The capital portion is subject to the usual capital-loss rules. The resulting tax savings depend on the investor’s full return; the ordinary classification is not a dollar-for-dollar tax credit.

Reporting and documentation

The ordinary portion is generally reported on Form 4797. Any capital portion is reported on Form 8949 and Schedule D under the applicable instructions. Retain subscription agreements, stock ledgers, proof of payment, capitalization and gross-receipts records, basis history, and documents establishing the disposition or year of worthlessness. Gains on the stock do not become ordinary merely because the stock qualified for Section 1244 loss treatment.

Section 1244 and Section 1202 are separate provisions. Section 1244 concerns qualifying losses; Section 1202 may exclude eligible gains under different requirements. Evaluate each independently when planning an investment or reporting its disposition.

This article provides general information, not individualized tax, legal, or investment advice. Eligibility and loss timing require a review of the corporation’s and shareholder’s records.

Sources: Internal Revenue Code § 1244; IRS Publication 550 (2025), “Losses on Section 1244 (Small Business) Stock”; IRS 2025 Instructions for Schedule D (Form 1040), “Small Business (Section 1244) Stock.”