Succeeding in Your Business: Dealing with taxes when you sell your stock

Cliff Ennico

“I invested in a small business corporation several years ago. The investment hasn’t worked out the way I thought it would, and now I’m looking for the exit door.

“Is there any way I can recoup some of my investment by taking a deduction on my taxes?”

The short answer to this question is “maybe.”

First, take a look at the corporation’s books and records, particularly the minutes of the initial meeting of incorporators or initial meeting of directors the corporation passed when it was first organized.

You are looking for three resolutions that will look something like this:

“RESOLVED, That stock of the Corporation that shall be issued by the Corporation to individuals or partnerships in consideration of money or other property (other than services, stock and securities), if at the time the Corporation is a 'small business corporation' as defined in Section 1244 of the Internal Revenue Code of 1986, as it shall be amended (the 'Code'), and which shall otherwise meet the requirements of 'Section 1244 stock' as defined in Section 1244 of the Code, shall be eligible to receive the benefits of the provisions of Section 1244 of the Code.

“RESOLVED, That stock of the Corporation that shall be issued by the Corporation to individuals, partnerships or corporations in consideration of money or other property (other than services, stock and securities), if at the time the Corporation is a 'qualified small business' as defined in Section 1202 of the Code, and which shall otherwise meet the requirements of 'qualified small business stock' as defined in Section 1202 of the Code, shall be eligible to receive the benefits of the provisions of Section 1202 of the Code.

“RESOLVED, that the Corporation shall deliver to its shareholders, the U.S. Department of the Treasury and the Internal Revenue Service any and all reports, documents and other information required by Section 1202(d)(1)(C) of the Code.”

If the corporation’s records contain all or some of these resolutions, you may be in luck.

Section 1244 of the U.S. tax code allows shareholders in “small business corporations” who are individuals or partnerships (not corporations) to deduct any losses they sustain when they dispose of their stock up to $50,000 for an individual or $100,000 for a married couple filing jointly. To qualify for the deduction:

• The C corporation must be incorporated in the U.S. (limited liability companies, S corporations and other entities do not qualify) with capital of not more than $1 million when the stock is issued. If a corporation raises more than $1 million in capital, only the first $1 million of stock can be “Section 1244 stock.”

• The corporation must make more than 50 percent of its gross income from active trades and businesses (not investments, real estate or other passive activities).

• The corporation must designate its stock as eligible for Section 1244 treatment (by adopting the resolution described above.)

• The investor must have paid cash or property for the stock. “Sweat equity” shares do not count.

For larger companies, Section 1202 of the code allows shareholders who are individuals or partnerships to exclude from federal income tax 100 percent of the capital gain incurred when selling “qualified small business stock” up to $10 million or 10 times the amount they paid for the stock (called the “adjusted basis”). To qualify for the benefits of Section 1202:

• The C corporation must be incorporated in the U.S. (limited liability companies, S corporations and other entities do not qualify) with gross assets having a value of not more than $50 million when the stock is issued.

• The corporation must be engaged in an “active business.” Not more than 10 percent of its assets can consist of stock, securities, real estate or other passive investments.

• The stock must be acquired after Dec. 31, 2014, and held for more than five years.

• The investor must have paid cash or property for the stock. “Sweat equity” shares do not count.

• The corporation and its shareholders must consent to supply documentation regarding “qualified small business stock” (by adopting the resolution described above).

If you acquired the stock prior to Dec. 31, 2014, and held it for more than five years, you may be able to exclude some of the capital gain (50 percent to 75 percent, depending upon when the stock was acquired), but a portion will be added back as a “preference” if you are subject to the alternative minimum tax. If, however, you use the proceeds of the stock sale to acquire “qualified small business stock” in another corporation within 60 days after receiving the proceeds, you can defer the gain on the sale under Section 1045 of the Code.

What if the corporation has not adopted resolutions making its stock eligible for Section 1202 or 1244 treatment? The resolutions may be adopted now as long as the corporation is within the eligibility thresholds (up to $1 million in capital for Section 1244, $50 million in assets for Section 1202).

Just be careful when asking for this. Company founders may be reluctant to pass these resolutions if they think you will dump your shares in the near future.

Cliff Ennico (crennico@gmail.com) is a syndicated columnist, author and former host of the PBS television series “Money Hunt.”

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