Clark & Trevithick | Writing Off Small Business Capital Investments

February 4, 2010 Volume 2, No. 1

This edition of Currents is from Dean I. Friedman, Esq. a taxation partner of the firm. Please contact Dean at dfriedman@clarktrev.com to inquire about the subject matter of this issue.

Writing Off Small Business Capital Investment

While General Motors Corporation and American International Group may be considered by U.S. lawmakers as too big to fail and deserving of taxpayer rescue, the recession which began in the final months of 2008 has also played havoc with the stock of many small businesses (those with fewer than 500 employees). Some entrepreneurs may choose to ride out the financial and economic meltdown, hoping that increasing optimism over emerging signs of recovery, even if short-lived by reason of modest inflation, persistently tight credit markets, the prospect of higher interest rates and taxes and stubbornly high unemployment, will nevertheless foster a profitable return on their small business investments. Small business owners are expecting 2010 to remain challenging (see, for example, Los Angeles Times, C. Zwahlen, For 2010, Painful Steps to Stay Afloat, December 29, 2009, Pages B1, B7). While the Obama administration remains hopeful that "targeted" financial and economic stimuli will indirectly aid small businesses, for small business owners and investors there really is no government-funded bailout.

Perhaps the federal tax laws can help! This edition of Currents summarizes how certain statutory tax write-offs and deductions may allow for the partial recovery of small business investment losses, defining what qualifies, what does not, and explaining how many invested dollars can effectively be recouped.

Section 1244 Stock
Section 1244 of the Internal Revenue Code ("IRC") provides that a loss on the sale of "Section 1244 Stock" is treated as ordinary (rather than capital) even though the shares are held for investment (and would otherwise qualify for short-term or long-term capital gains tax treatment if sold or exchanged profitably). To be Section 1244 Stock, five requirements must be cleared, four of which must be met when the shares are originally issued:
            (i)    The shares may be common or preferred;
            (ii)   The company must be domestically chartered;
            (iii) The company must also be a "small business," meeting the $1 million "Capital Receipts Test" described below; and,
            (iv) The shares must be issued for money or property, not for services rendered, nor for other stocks or securities.

Compliance with the additional fifth requirement, the "Gross Receipts Test," is determined when the small business shares are sold and the investment loss recognized: The Gross Receipts Test is different than the Capital Receipts Test. The corporation must satisfy the Gross Receipts Test during each of its five taxable years preceding (ending before) the stock sale (or during each of its preceding taxable years if incorporated fewer than five taxable years before the stock sale), deriving more than half of its revenue from sources other than royalties, rents, dividends, interest, annuities and sales or exchanges of stocks and securities. The purpose of the fifth requirement is to insure that favorable Section 1244 Stock tax treatment is available only to enterprises engaged in active trades or businesses.

The third requirement can be a bit tricky to apply. The Capital Receipts Test is a one-way street. Subsequent capital distributions (such as through share redemptions) are not subtracted, so once the $1 million amount of capital investment is received by the issuing corporation, no additional issuance of shares can qualify for ordinary loss treatment. Shares issued after the Capital Receipts test limitation has been exceeded cannot qualify as Section 1244 Stock, but shares issued before then are not retroactively disqualified. The corporation may designate in its records which shares are intended to qualify as Section 1244 Stock and which shares do not qualify. Simply stated, there can be no substitution of new capital for old capital. Property (rather than money) contributions to capital or as paid-in surplus made in a tax-free manner (such as under IRC section 351) are counted towards the $1 million limit according to the contributing shareholder's basis in that property, net of associated liabilities. By comparison, taxable contributions are credited at fair market value.

The ordinary loss deduction is limited in a single taxable year to $100,000 for a married couple ($50,000 for a single taxpayer). Any loss sustained in excess of this limitation is treated as a capital loss and is eligible for carryover treatment (discussed below) into succeeding taxable years.

Finally, the holder of Section 1244 Stock must be an individual directly owning the shares, or indirectly owning them through a partnership. And those shares must be an original issuance. Accordingly, capital shares acquired through an investment banking firm or other brokering agent may qualify as Section 1244 Stock so long as not first issued to that investment banking firm or brokering agent. Shares first purchased by an investment banking firm or brokering agent and then resold to an individual shareholder will not qualify for ordinary loss treatment.

Capital Loss Write-Off Limitations and Carryovers
An individual investor's net short-term or long-term capital losses not otherwise offset against capital gains during the current taxable year may not be carried back to an earlier taxable year in which capital gains were realized. However, under IRC section 1212, those "net capital losses" may be carried forward indefinitely and without regard to maximum amount. The carry-forward may offset an unlimited amount of subsequently derived capital gains. Net capital losses carried forward retain their character as long-term or short-term capital losses. Holding periods of not more than one year determine short-term gains and losses. Periods of more than one year determine long-term gains and losses.

The carry-forward may also offset a limited amount of ordinary income in succeeding taxable years (a maximum of $3,000 per taxable year). Where an individual investor has both excess long-term and short-term capital losses in a taxable year that exceed the limited ordinary income offset limitation, taxable income in succeeding taxable years is first reduced by the short-term losses.
Example. Investor realized $4,000 of short-term and $10,000 of long-term capital losses in 2009. She may deduct $3,000 of her short-term capital losses against her 2010 ordinary income, leaving a $1,000 short-term capital loss carryover and a $10,000 long-term capital loss carryover to write off in 2011.

Worthless Securities
Finally, special rules apply to the write off of worthless securities or their "abandonment." Under IRC section 165(g), if a capital asset share becomes worthless during the taxable year, the resulting loss is treated as a capital loss on the last day of that year. It is the worthlessness of the stock which evidences a closed and completed transaction necessary to claim a loss. For this purpose, a "security" includes stock, a right to subscribe to stock such as a warrant and a bond, debenture or note in registered form (meaning recorded on the company's records and transferable only if recorded on such records).

The key here is "worthlessness." A deduction of the resulting loss can only be claimed in the taxable year in which the complete worthlessness of the security occurs, so that an investor must show that the security had value in the immediately preceding taxable year. Both present and future worth are relevant to the determination (such as a reasonable hope and expectation that company assets will exceed liabilities in a future taxable year). The presence of potential worth nullifies the deduction of the loss. ?The loss may be treated as a long-term capital loss as a result of this requirement (as opposed to recognizing the loss sooner). It is the adjusted basis of the security on the last day of that year that determines the loss amount.

A shareholder may also permanently surrender and relinquish all rights in a security. The resulting loss from this "abandonment" is also treated a loss from a sale or exchange of a capital asset on the last day of the taxable year, a capital loss. No consideration may be received from the issuer. Controlling shareholders who abandon or surrender part of their shares to the issuing corporation and otherwise retain control are deemed to have made a contribution to capital and do not incur a deductible loss, be it capital or ordinary.

Currents is intended to be educational only. It is designed to provide our clients and friends with the discussion of current topics and legal authorities as applied to those topics. Currents is not intended to constitute legal advice or provide any opinion about the application of such legal authorities to a particular circumstance, set of facts or situation. In addition, that you have received transmission of Currents does not create any relationship of attorney and client between Clark & Trevithick, PLC and you.

Clark & Trevithick, PLC is a full service law firm representing clients throughout California and western states for more than three decades. Our practice includes specialization in federal and state taxation law and tax reporting compliance, as well as estate planning for owners of closely-held businesses and other high net worth individuals. We also counsel on the sale of closely-held businesses. We develop methods for transferring wealth to surviving spouses and descendants by the most efficient and tax-advantaged methods available. Our practice profile also includes corporate, real estate, litigation, creditors' rights and remedies and employment law matters.

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