IRC §1244 was meant to encourage investing in small operating corporations by allowing for a limited ordinary income deduction for a loss on disposing of such stock. IRC §1244(a) provides:

(a) General rule

In the case of an individual, a loss on section 1244 stock issued to such individual or to a partnership which would (but for this section) be treated as a loss from the sale or exchange of a capital asset shall, to the extent provided in this section, be treated as an ordinary loss.

The cap on the maximum §1244 loss for a single tax year is found at IRC §1244(b):

(b) Maximum amount for any taxable year

For any taxable year the aggregate amount treated by the taxpayer by reason of this section as an ordinary loss shall not exceed—

(1) $50,000, or

(2) $100,000, in the case of a husband and wife filing a joint return for such year under section 6013.

Section 1244 stock is defined at IRC §1244(c)(1):

(c) Section 1244 stock defined

(1) In general

For purposes of this section, the term “section 1244 stock” means stock in a domestic corporation if—

(A) at the time such stock is issued, such corporation was a small business corporation,

(B) such stock was issued by such corporation for money or other property (other than stock and securities), and

(C) such corporation, during the period of its 5 most recent taxable years ending before the date the loss on such stock was sustained, derived more than 50 percent of its aggregate gross receipts from sources other than royalties, rents, dividends, interests, annuities, and sales or exchanges of stocks or securities.

A small business corporation is defined at IRC §1244(c)(3) which provides:

(3) Small business corporation defined

(A) In general

For purposes of this section, a corporation shall be treated as a small business corporation if the aggregate amount of money and other property received by the corporation for stock, as a contribution to capital, and as paid-in surplus, does not exceed $1,000,000. The determination under the preceding sentence shall be made as of the time of the issuance of the stock in question but shall include amounts received for such stock and for all stock theretofore issued.

(B) Amount taken into account with respect to property

For purposes of subparagraph (A), the amount taken into account with respect to any property other than money shall be the amount equal to the adjusted basis to the corporation of such property for determining gain, reduced by any liability to which the property was subject or which was assumed by the corporation. The determination under the preceding sentence shall be made as of the time the property was received by the corporation.

In the case of Ushio v. Commissioner, TC Summary Opinion 2021-27[1] the taxpayers attempted to claim a $50,000 ordinary loss on what the taxpayers claimed was Section 1244 stock. The taxpayers were not successful in claiming the ordinary deduction.

The taxpayer invested $50,000 via a stock subscription agreement for 50 shares of PCHG, a South Carolina corporation. The corporation did not have gross receipts at any time during its existence, ceased business in 2012 and was administratively dissolved by the state of South Carolina in 2013.[2]

PCHG’s operations while in existence were described in the opinion as follows:

PCHG planned on investing in LifeGrid Solutions, LLC (LGS), for the purpose of enabling LGS and Lifetime Solutions, LLC, a Nevada limited liability corporation, to obtain rights in a process related to alternative energy. PCHG signed an undated agreement with LGS and Lifetime Solutions that stated that Lifetime Solutions had entered into an agreement with D4 Energy Group, Inc., to obtain the rights to the D4 process, that LGS wanted to obtain the right to use the D4 process in its own projects, and that Lifetime Solutions and LGS had started discussing and negotiating the use of the D4 process. PCHG had invested $125,000 in LGS and, pursuant to the undated agreement, intended on investing a total of $400,000. That agreement also stated that LGS, PCHG, and Lifetime Solutions agreed to “participate in, develop, operate and conduct business related to alternative and renewable energies utilizing D4 Energy Group technologies and processes on an exclusive basis” and not to circumvent or compete unless they obtained written permission.

On September 10, 2009, PSG, PCHG, and LGS agreed in writing “to establish the profit sharing and technology transference relationship and non-compete terms between PSG, * * * [PCHG] and their respective principal partners and Officers.” PSG agreed to distribute 30% of all LGS energy-related distributions PSG received directly to PCHG in consideration of an investment by PCHG in PSG of $360,000.[3]

The IRS argued the taxpayers had failed to show this stock qualified as Section 1244 stock and the Tax Court agreed. A key issue was that PCHG had no operations, and failed to meet the requirements found at IRC §1244(c)(1)(C) that the corporation had to derive over 50% of its aggregate gross receipts during the five most recent taxable years from sources other than royalties, rents, dividends, interests, annuities, and sales or exchanges of stocks or securities. The taxpayers also failed to show that the corporation met the rules that limited the total amount received for stock not exceed $1 million found at IRC §1244(c)(1)(B)

The opinion noted the purpose of Section 1244 was to encourage investment in operating businesses:

Congress intended section 1244 to encourage taxpayers to invest new funds in small businesses, rather than provide favorable tax treatment for losses suffered by investment and holding companies. Bates v. United States, 581 F.2d 575, 579-580 (6th Cir. 1978) (citing H.R. Rept. No. 85-2198 (1958), 1959-2 C.B. 709, 710); Davenport v. Commissioner, 70 T.C. 922, 927 (1978) (citing H.R. Rept. No. 85-2198, supra, 1959-2 C.B. at 711). The Secretary issued regulations which provide that the taxpayer must show that the corporation was “largely an operating company” during the five-year period described above even if the gross receipts requirement does not apply because the corporation’s deductions exceed its net income. Sec. 1.1244(c)-1(e)(2), Income Tax Regs.[4]

The Court first discusses the lack of a showing that the corporation met the less than $1,000,000 received for stock requirement:

The record shows that the PCHG stock was issued for money. However, the record does not support a claim that the other two requirements of section 1244 were met. PCHG was not a small business. For a corporation to be a small business corporation under section 1244 the aggregate amount of money and other property (other than stock and securities) received by the corporation for stock must not exceed $1 million. Sec. 1244(c)(3)(A). The determination shall be made as of the time of the issuance of the stock in question and includes amounts received for all stock issued up to that date. Id. Mr. and Ms. Ushio presented a document that they claimed showed that the aggregate amount of money and other property that PCHG received for its stock did not exceed $1 million. However, that document is undated and was not adequately explained further. The document includes a column titled “Cash Input” and a column titled “Deferred Pay”. Mr. and Ms. Ushio assert that the deferred payment was not made and therefore the amount paid for the PCHG stock did not exceed $1 million. However, the evidence does not support that assertion. Therefore, Mr. and Ms. Ushio have not proven that the amount of money that was paid for the PCHG stock did not exceed $1 million.[5]

And the Court also pointed out the fact the corporation had no operations:

Further, during its existence more than 50% of PCHG’s aggregate gross receipts were not from sources other than royalties, rents, dividends, interests, annuities, and sales or exchanges of stocks or securities. In fact PCHG could not meet this requirement because it did not have any gross receipts during its existence and failed to operate largely as an operating company. Mr. and Ms. Ushio argue that it was PCHG’s intention to engage as an operating company in a business related to alternative energy. However, the record is devoid of any evidence to prove that and, in fact, a signed agreement in the record indicates that PCHG was to receive a return on its investment in LGS.[6]

[1] Ushio v. Commissioner, TC Summary Opinion 2021-27, August 16, 2021, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/couple-not-entitled-to-ordinary-loss-deduction-for-worthless-stock/77602 (retrieved August 21, 2021)

[2] Ushio v. Commissioner, TC Summary Opinion 2021-27, August 16, 2021

[3] Ushio v. Commissioner, TC Summary Opinion 2021-27, August 16, 2021

[4] Ushio v. Commissioner, TC Summary Opinion 2021-27, August 16, 2021

[5] Ushio v. Commissioner, TC Summary Opinion 2021-27, August 16, 2021

[6] Ushio v. Commissioner, TC Summary Opinion 2021-27, August 16, 2021