What it means
Section 1202 rewards the startup that wins; Section 1244 comforts the one that fails. Losses on qualifying small business stock deduct as ordinary losses, sidestepping the capital-loss straitjacket.
The ordinary-capital distinction is the whole prize: capital losses mostly offset capital gains, with only $3,000 a year against ordinary income, while an ordinary loss deducts fully against salary or business income. The Cornell text of 26 USC 1244 defines the protection: losses on stock in qualifying small corporations are ordinary up to $50,000 a year, or 100,000 on a joint return.
Qualification has its own checklist: the stock must be issued for money or property by a domestic small corporation, and the company must have earned most of its receipts from active operations, not passive income. Only the original holder benefits: buy the shares from someone else and the 1244 protection does not transfer, a rule that keeps the comfort aimed at genuine early backers.
The two small-business sections complement rather than overlap: 1202 sweetens the five-year winner's gain, 1244 softens the loser's write-off, and founders check both at incorporation. The planning is quiet but real: documenting 1244 qualification costs little at formation and pays off exactly in the scenarios nobody wants to discuss at the celebration.
For a non-finance reader, Section 1244 is the tax code's parachute for small-business risk: if the venture crashes, the loss lands where it does the most good, against ordinary income. The definition of small is drawn tight: the corporation's capital receipts plus the new stock's proceeds must stay within the statutory ceiling, a line that keeps the benefit aimed at genuinely small ventures.
Documentation is the whole game in practice: a board resolution designating the stock, records of what was paid for it, and the company's gross-receipts history are the file the deduction will one day stand on. Partnerships and LLC interests sit outside the tent: 1244 speaks only of stock in a corporation, so the pass-through world that dominates modern small business cannot use the parachute.
The provision predates the startup era by decades: Congress wrote it in 1958 to steer capital toward small enterprise, making it the grandfather of every small-business tax break that followed.
In practice
Real-world examples.
Example
A couple's startup shares become worthless, and the $100,000 qualifying loss deducts as an ordinary loss against their practice income in the same year. The deduction offsets high-taxed earnings immediately instead of dripping out over decades. The parachute opened on schedule.
Example
An investor buys shares from an earlier backer instead of from the company at issue. Because only the original holder gets Section 1244 treatment, the same $100,000 loss is a capital loss and offsets ordinary income at just $3,000 a year once capital gains are used up. The shares looked identical, but the protection did not travel with them.
Example
A founder and her angel investors check Section 1244 qualification at incorporation, confirming that the stock is issued for money or property by a domestic corporation within the statutory capital ceiling of $1,000,000 and that most receipts come from active business. They keep the board resolution and payment records on file. The documentation costs little and is the file any future loss will stand on.
Formula
Calculation
Ordinary loss limit: up to $50,000 per year, or $100,000 on a joint return, on qualifying small business stock; any excess loss remains a capital loss under the usual capital-loss rules.
Worked example: a married couple filing jointly holds original-issue qualifying shares that cost $120,000 and become worthless. The ordinary loss is limited to $100,000, and the other $120,000 - $100,000 = $20,000 is a capital loss. At an assumed 30% marginal tax rate, the $100,000 ordinary deduction saves $100,000 x 30% = $30,000 of tax. Had the whole $120,000 been a capital loss with no capital gains to absorb it, only $3,000 a year could offset ordinary income, saving $3,000 x 30% = $900 in the first year.Case study
Seen in the real world.
This case study is fictional and illustrative. A made-up physician invests $120,000 at incorporation in a neighbour's medical-device company, documented as 1244 stock from day one. Four years later the device fails its pivotal trial, the company winds down, and her shares are worthless. Her accountant delivers the consolation the paperwork was bought for: $100,000 of the loss, the joint-return limit, deducts as an ordinary loss against the couple's practice income that year, while only the remaining $20,000 drips out under capital-loss rules.
The comparison with the unlucky alternative is stark: a colleague who bought the same kind of shares from an existing holder rather than from the company was not an original holder, so his identical loss deducts at $3,000 a year against ordinary income, a trickle that will outlive the memory of the company itself. The physician's summary to her investment club becomes the section's best advertisement: nobody invests in a startup planning to use 1244, but the one time you need it, it is the difference between a bad year and a bad decade, and the documentation costs less than dinner. Her club's checklist now puts the 1244 qualification memo beside the term sheet on every deal.
Watch out
Common mistakes.
- Assuming all small-company stock qualifies; the issuance, corporate size, active-income, and original-holder tests all must be met and documented.
- Expecting the benefit to follow the shares; only the original holder gets ordinary-loss treatment, so secondary buyers inherit no protection.
- Forgetting the cap; ordinary treatment stops at the annual limits, and the remainder falls back into the capital-loss rules.
Questions
People also ask.
What is Section 1244 stock?
Qualifying small corporation stock whose loss deducts as an ordinary loss, up to $50,000 a year or 100,000 jointly, instead of a capital loss.
Why does ordinary matter?
Capital losses barely offset ordinary income, capped at $3,000 a year, while ordinary losses deduct fully against wages and business income.
Who qualifies?
Only original holders of stock issued for money or property by a domestic small corporation earning most receipts from active business.
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