A recent Tax Court decision, Virgil D. Rath (Rath) (101 TC No. 13), has affirmed that ordinary loss treatment on Sec. 1244 stock is available only to individuals and partners in partnerships. The ruling held that if IRC Sec. 1244 stock is issued to S corporations, such corporations and their shareholders may not treat losses on such stock as ordinary losses. This is so notwithstanding IRC Sec. 1363, which provides that the taxable income of an S corporation must be computed in the same manner as that of an individual.

General Rules

Stock issued to an individual or a partnership and meeting certain requirements qualifies as IRC Sec. 1244 stock. If the stock is subsequently sold at a loss or becomes worthless, such losses may be treated as ordinary losses rather than capital losses. The taxpayer benefits because ordinary losses are fully deductible and are not subject to the IRC Sec. 1211 (b) limit on the deductibility of such losses to individuals of $3,000 per year in excess of capital gains.

Individuals may deduct up to $50,000 per taxable year of losses on IRC Sec. 1244 stock as ordinary losses. The annual limit for married couples filing jointly is $100,000. Any losses in excess of these amounts must be reported as capital losses and are subject to the annual limits on such losses.

Definition of IRC Sec. 1244 Stock

For stock to qualify as IRC Sec. 1244 stock, the following requirements contained in Reg. Sec. 1.1244 must be met.

* The stock may only be common stock.

* The corporation issuing the stock must qualify as a small business corporation at the time the stock is issued.

* A taxpayer must transfer money or other property to the issuing corporation in exchange for the stock.

* The corporation must pass a "gross receipts" test at the time any loss on the stock is sustained by a shareholder.

Except for the gross receipts test, each requirement must be met at the time the stock is issued.

Common Stock. To qualify as IRC Sec. 1244 stock, the stock must be issued by a domestic corporation, and it must be either voting or non- voting common stock. Preferred stock may not qualify as IRC Sec. 1244 stock. In addition, for purposes of IRC Sec. 1244, common stock convertible into other securities of the corporation and securities convertible into common stock are not treated as common stock.

Small Business Corporation. To qualify as a small business corporation, the entity must be a domestic corporation with capital receipts, including paid-in surplus as well as contributed capital, not exceeding $1 million at the time the IRC Sec. 1244 stock is issued. Subsequent distributions to shareholders, even if capital in nature, do not reduce the amount of capital receipts. Thus, it is not possible for a corporation that has reached or exceeded the $1 million threshold to qualify to issue more IRC Sec. 1244 stock by paying dividends or making distributions of other corporate assets to shareholders.

If the corporation's capital stock will not exceed $1 million by the end of the taxable year, it is not necessary for the corporation to designate issued stock as IRC Sec. 1244 stock. The stock will automatically qualify as long as all other requirements have been met.

Exceeding the $1 Million Limitation. In the first taxable year that a corporation's aggregate capital receipts exceed $1 million, the corporation must designate which shares issued in that transitional year are IRC Sec. 1244 shares. The corporation is required to make the designation by the 15th day of the third month following the end of the taxable transitional year. The designation is accomplished by entering the numbers of the qualifying share certificates on the corporation's records.

If a corporation does not designate which shares issued in the transitional year are IRC Sec. 1244 shares, subsequent losses will be allocated in the following manner. Subject to the annual limitations, shares issued in years prior to the transitional year will receive IRC Sec. 1244 (ordinary loss) treatment. The amount of ordinary loss allowed for shares issued in the transitional year is subject to the annual limitations and will be determined by multiplying the amount of the transition year loss by the following ratio: $1 million--capital stock issued in prior yrs. Capital stock issued in the transition year

Example. Corporation A, a newly formed entity, issues common stock to Shareholder A in 1991 in exchange for $700,000 in cash and property. During 1992, the corporation issues additional shares to Shareholder B for $400,000 in cash. More shares are issued to Shareholder C during 1993 for $100,000. Corporation A fails to designate any of the shares as IRC Sec. 1244 stock. In 1994, all shareholders sell some or all of their shares at a loss. Subject to the annual limitation, Shareholder A may treat his or her entire loss as an ordinary loss under IRC Sec. 1244. Excess losses are treated as capital losses. On the other hand, Shareholder B may treat only 75% ($300,000/400,000) of his or her loss, subject to the annual limitation, as an ordinary loss under IRC Sec. 1244. Any remaining loss must be treated as a capital loss. None of Shareholder C's losses qualify for IRC Sec. 1244 treatment.

Stock Issued for Money or Other Property. Stock must be issued to the taxpayer in exchange for cash or other property transferred to the corporation. Stock issued in exchange for securities issued by other corporations or by the issuing corporation does not qualify as IRC Sec. 1244 stock. Exception to this rule applies for stock issued 1) as part of a stock dividend or 2) in exchange for other stock as part of a reorganization pursuant to IRC Sec. 368 (a) (1) (E) or IRC Sec. 368(a) (1) (F). Stock issued to satisfy a debt of the corporation may be treated as issued in exchange for money or other property, unless the debt is evidenced by a security or arose out of the performance of personal services. Services rendered, or to be rendered to the corporation, do not qualify as money or other property. Thus, any stock issued in exchange for services will not qualify as IRC Sec. 1244 stock.

Basis of Shares. Pursuant to IRC Sec. 351, the basis for IRC Sec. 1244 shares received in exchange for property is generally the adjusted basis of the property at the time of the exchange less any liens to which the property is subject. However, for purposes of IRC Sec. 1244 only, the basis of the shares must be reduced to the aggregate fair market value of the exchanged property if such fair market value is less than the property's adjusted basis.

Example. Shareholder X transfers business assets with a basis of $130,000 and a fair market value of $115,000 to a corporation in exchange for 1,000 shares of IRC Sec. 1244 stock. The basis of the shares received is $130,000. However, for IRC Sec. 1244 purposes, the basis is $115,000, the aggregate fair market value of the property transferred.

Increases in Basis of IRC Sec. 1244 Stock. Once IRC Sec. 1244 stock is issued, a shareholder's basis in the issued stock, for purposes of IRC Sec. 1244, may not be increased by making additional contributions of cash or property to the issuing corporation. Unless additional shares are issued by the corporation to the shareholder, subsequent investments in the corporation are treated as investments in stock that is not IRC Sec. 1244 stock. The corporation must issue new shares to the shareholder at the time of the additional investment for the investment to be treated as an investment in IRC Sec. 1244 stock.

Thus, if a shareholder increases his or her basis in IRC Sec. 1244 stock without receiving additional shares of IRC Sec. 1244 stock, any subsequent losses on the stock must be allocated between ordinary (IRC Sec. 1244) losses and capital (non-IRC Sec. 1244) losses.

Example. Corporation Y issues 100 shares of IRC Sec. 1244 stock to Shareholder X in exchange for $7,000. Each share has a basis for purposes of IRC Sec. 1244 of $70. Later, the shareholder invests an additional $3,000 in the corporation without receiving any more shares. The following year, the shares are sold for $8,000. Of the $2,000 loss, assuming all other requirements are met, $1,400 $7,000/10,000) x $2,000 is treated as an ordinary loss under IRC Sec. 1244. The remaining $600 loss is allocated to the portion of the stock that does not qualify as IRC Sec. 1244 stock, and is treated as a capital loss.

Gross Receipts Test. The gross receipts test is designed to insure the corporation is operated as an active business. Thus, stock will not qualify as IRC Sec. 1244 stock if 50% or more of a corporation's gross receipts are derived from royalties, rents, dividends, interest, annuities, and sales or exchanges or stock or securities.

This test applies to the corporation's five most recent taxable years ending before the date on which a shareholder sustains a loss on the stock. If the corporation has not been in existence for at least five years before the date of loss, the test is applied to the actual taxable years the corporation existed ending before the date of loss. If the loss occurred during the first year of the corporation's life, the applicable time period runs from the first day of the first taxable year to the day before the date of loss.

For purposes of this test, the term "gross receipts" means the total amount received or accrued under the accounting method used by the corporation in computing its taxable income. This amount is not reduced by sales returns and allowances, cost of goods sold, or deductions. Thus, gross receipts is not synonymous with the term "gross income." However, when considering sales or exchanges of stock or securities, only the gain from such transactions is to be included. In addition, except for recognized gains, amounts received in non-taxable exchanges are not included as part of gross receipts.

IRC Sec. 1363(a) provides that an S corporation is generally not subject to federal income taxes. However, under IRC Sec. 1363(b), an S corporation's taxable income is to be computed in the same manner as in the case of an individual. Items of income, gain, loss, deduction, and credit are passed through to the shareholders on a pro rata basis. Certain "separately stated" items are also passed through to individual shareholders.

In addition, the character of each passthrough item is to be determined as if realized directly from the same source as realized by the corporation or incurred in the same manner as incurred by the corporation.

The Rath Decision

Rath International, Inc. (International) was organized in 1971 by Virgil D. Rath and James R. Sanger, with each taxpayer owning 50% of the outstanding shares. In 1985, International elected, under IRC Sec. 1362(a), to operate as a S corporation. The company continued to operate as an S corporation throughout its taxable year ending December 31, 1986. Rath and Sanger also owned all of the outstanding shares of Rath Manufacturing Co., Inc. (Rath Manufacturing) during the time period relevant to this case.

In 1986, International and its attorney, James Dodson, acquired an option to purchase stock from River City, Inc. Rath and Sanger each borrowed $125,000 from Rath Manufacturing and invested the loan proceeds in International as contributions to capital. International used the capital infusion to exercise the option, acquiring 225 shares of River City stock in April 1986.

The River City stock was subsequently sold by International in September 1986 for $100. River City ceased operations in October 1986.

On their 1986 individual income tax returns, Rath and Sanger each reported a loss of $124,950 on the sale of the River City stock. Rath's IRC Sec. 1244 loss was $50,000 while Sanger's amounted to $100,000, which was the maximum IRC Sec. 1244 loss allowable for each of them based on their filing status. They treated the amount of the remaining losses as capital losses. However, the loss was not reported on International's return for that year, and it was not treated as a flow- through loss from International by Rath and Sanger.

Position of the IRS. Rath and Sanger each received a notice of deficiency from the IRS stating that the taxpayers did not qualify to deduct any of the loss incurred on the sale of the River City stock as an ordinary loss under IRC Sec. 1244 (a). The IRS determined that IRC Sec. 1244 does not apply to River City's stock because the stock was issued to International, an S corporation, rather than to the individual taxpayers. It ruled that Rath and Sanger must deduct their losses as capital losses.

Position of the Taxpayers. The taxpayers argued that IRC Secs. 1363(b) and 1366(b) operate to make IRC Sec. 1244 applicable to their situation. They maintained the flow-through provision of Sec. 1366(b) enables shareholders of an S corporation to deduct their pro rata share of losses incurred by the S corporation on the sale of IRC Sec. 1244 stock issued to the corporation.

Further, Sanger and Rath contended that under IRC Sec. 1366(b) the shareholders of an S corporation are treated as if the items of income and deduction that flow through to them were realized by them directly from the source. Thus, for purposes of determining the character of the loss under IRC Sec. 1366(b), they concluded the shareholder steps into the position of the S corporation, and is deemed to have entered into the same transaction as the S corporation.

The taxapayers also argued that the legislative history of IRC Sec. 1366 proves that Congress intended the character of items passed through to S corporation shareholders be determined in the same manner as items passed through to partners of partnerships. They reasoned that Congress intended for ordinary losses on IRC Sec. 1244 stock to be passed through to shareholders of S corporations in the same manner such losses would be passed through by partnerships to partners.

IRC Sec. 1363(b), providing that the taxable income of an S corporation is to be computed in the same manner as that of an individual, was cited as further support for their position. In addition, the taxpayers maintained that if Congress had not intended for shareholders of S corporations to receive ordinary loss treatment of IRC Sec. 1244 stock, it would have excluded S corporations from the definition of "individuals" in IRC Sec. 1244(d). IRC Sec. 1244(d) states that, for purposes of IRC Sec. 1244, the term "individual" does not include a trust or estate. The section makes no reference to S corporations. Rev. Rul. 93-36 was also cited as support for the position of taxing S corporation shareholders like partners.

As a final argument, the taxpayers maintained their position is fair and supported by policy considerations. The fact they were the sole shareholders of International, they argued, made them the only true shareholders with respect to income or loss from the IRC Sec. 1244 stock issued to International.

Ruling of the Tax Court. The Court noted that under Regs. Sec. 1.1244(a)-1(b), only individuals and partners in partnerships are entitled to treat losses on IRC Sec. 1244 stock as ordinary losses. The stock must have been issued directly to the individual shareholder or to the partnership. The regulation specifically states that "a corporation, trust, or estate is not entitled to ordinary loss treatment under IRC Sec. 1244 regardless of how the stock was acquired."

Thus, if considering only IRC Sec. 1244, the taxpayers would be precluded from treating their losses as ordinary. However, the Court also addressed the arguments raised by the taxpayers citing IRC Secs. 1363 and 1366.

The Conduit Rule. The Court ruled that IRC Sec. 1366(b) does not support the taxpayers' position that shareholders of an S corporation step into the shoes of the corporation. It noted the language used in IRC Sec. 1366(a) was essentially identical to that of IRC Sec. 702(b). IRC Sec. 702(b) provides a conduit rule in which the character of items of income, deduction, gain, loss, or credit of a partnership are determined at the partnership level and passed through to individual partners. The rule was articulated in Podell (55 TC 429) in which the Tax Court held that rather than view pass-through items from the point of view of the individual partners, the nature of such items must be determined from the viewpoint of the partnership.

Congress enacted IRC Sec. 1366(b) in 1982 to simplify the taxation of income earned by S corporations. The legislative history of IRC Sec. 1366(b) provided that the new rules for S corporations generally follow the rules regarding the taxation of partnerships. Thus, the conduit rule regarding the character of items passed through to S corporation shareholders will be the same as the rule for partners and partnerships. Hence, the character of items passed through to S corporation shareholders must be determined at the entity level.

The Court held the taxpayers' interpretation of the interaction between IRC Sec. 1244(a) and IRC Sec. 1366(b) was incorrect. IRC Sec. 1366(b) does not require the taxpayer to take the place of the corporation when determining the character of items passed through from the S corporation to the shareholder. Rather, IRC Sec. 1366(b) requires the character of such items to be determined at the corporate level before the pass through occurs. Thus, because an S corporation does not qualify for ordinary loss treatment under IRC Sec. 1244(a), the losses incurred on the River City stock and passed through to Rath and Sanger were capital losses and not ordinary losses.

Response to Other Taxpayer Arguments. In addition, the Court rejected the taxpayers' position that the legislative history of IRC Sec. 1366(b) supported their position. The Court agreed with the taxpayers that it would have been logical for Congress to extend IRC Sec. 1244(a) treatment to S corporations when it amended subchapter S in 1982. However, because the Court found no evidence in the legislative history that Congress intended to make such a change, it felt compelled to apply IRC Sec. 1244(a) as written.

The taxpayer's argument regarding IRC Sec. 1363(b) was also rejected by the Court. IRC Sec. 1363(b) provides that an S corporation's taxable income is to be computed in the same manner as that of an individual. However, the court noted that, under IRC Sec. 1244(d), an S corporation does not qualify as an individual. By way of comparison, the Court noted that, for purposes of subchapter C, S corporations that hold shares in other corporations are treated as individuals under IRC Sec. 1371(a). Applying the conduit approach, this provision effectively denies the dividends received deduction of IRC Sec. 243(a) to shareholders of S corporations. Congress was able to enact a provision such as IRC Sec. 1371(a) targeting shareholders in a specific type of corporation regarding a specific type of transaction. The Court saw this as evidence that Congress could have provided relief for S corporations regarding IRC Sec. 1244 stock if it had chosen to do so.

Also rejected was the taxpayers' position that they, not International, were the true holders of the River City stock, and that fairness dictated that they be allowed an ordinary loss deduction. The Court interpreted this argument as a request that it disregard the status of the corporate entity in favor of the individual shareholders. The Court explained that, pursuant to Moline Properties, (319 U.S. 436), if the corporation is organized to carry on business activities or for other legitimate purposes, the corporate status may not be ignored for purposes of taxation.

Having rejected all arguments put forth by the taxpayers, the Tax Court held for the IRS. The taxpayers were required to treat the loss passed through to them on the sale of the River City stock as a capital loss.

Tax Planning

Taxpayers may reap the benefits of investing in both S corporations and in IRC Sec. 1244 stock. However, they must be careful to satisfy all requirements necessary to qualify under both provisions.

Shareholders in S corporations who plan to invest in IRC Sec. 1244 stock issued by other corporations should be certain to 1) acquire the stock directly from the issuing corporation themselves or 2) purchase the stock through a partnership in which they are partners. Assuming all other requirements are met, the stock will qualify as IRC Sec. 1244 stock, and the taxpayers may deduct, subject to the annual limitations, as ordinary losses, any future losses realized on the stock.

An additional tax planning strategy would be to have the S corporation also issue IRC Sec. 1244 stock to the shareholders. This way, the taxpayers will be certain to realize the best of both worlds. They receive the benefit of having items of income and deduction passed through to them from the S corporation. In addition, should they subsequently sell the S corporation stock at a loss, the loss would be deductible as an ordinary loss, subject to the annual limitations, rather than as a capital loss.