Long-term capital gains taxed lower than ordinary income

We recently helped a client close down and liquidate a corporation that was no longer wanted or needed. Because the stockholder had invested in the corporation stock when it was formed and it had sustained losses, the stock qualified for a special tax benefit as Section 1244 stock.

Congress put that code section in the law a long time ago. It is unusual in that it is sort of a “heads you win and tails you don’t loss as much” situation. If the sale or liquidation of the corporation results in a gain (the value of assets that are transferred to the stockholder is greater than the cost of the stock) it is long-term capital gain.

If, as in our client’s case, the value of assets was less than the investment in the common stock, so the loss is an ordinary loss, subject to the rules and limitations.

Long-term capital gains are taxed at lower rates than ordinary income, a good benefit.

The ordinary loss offsets other ordinary income and is more valuable than capital loss.

However, some of the rules are:

• The corporation must qualify for Section 1244 (more on that later).

• The aggregate amount of ordinary loss is limited to $50,000 on separate returns or single-person returns. The loss is limited to $100,000 on a joint return and is OK even if only one spouse owned the stock.

• The common or preferred stock must have been issued to you or a partnership for money or property (but not for your other stock or securities or services).

Of course there are other rules as well, but those are the main ones.

A corporation that qualifies for Section 1244 benefits must be a U.S. corporation that only had $1,000,000 of stock issued. During the corporation’s five most recent tax years ending before the date the stock is sold (liquidating counts as a sale), more than 50 percent of its gross receipts must have come from business operations (not royalties, rents, dividends, interest, annuities or gains from selling securities).

The ordinary loss may result in a net operating loss (NOL) for the individual investor.

That NOL can happen if the loss is greater than other taxable income in the year of sale. The rest of the NOL can then “carry back” to your second previous year, and you can get a refund of some of the tax paid then and have the basic NOL carryover rules apply.

As you probably know, a capital loss can offset capital gains and the excess loss gives only a $3,000 deduction on page one of your tax return. The rest of the capital loss carries forward to offset future capital gains and/or give a $3,000-per-year deduction.

If you reported the sale as capital loss and it is really a Section 1244 loss, the last three years returns can be amended to correct the reporting and get you some refunds.

Did you hear? “The easiest way to figure the cost of living is to take your income and add 10 percent.”