When a client's startup investment fails, the default result is a capital loss: it offsets capital gains plus $3,000 of ordinary income a year under Section 1211(b). With no gains, a $50,000 loss at a 32% bracket saves $960 in the first year.
Section 1244 of the Internal Revenue Code (IRC Section 1244) changes that. If the stock qualifies, you can treat up to $50,000 of the loss as ordinary ($100,000 on a joint return) and deduct it against wages, business income, or anything else in the year the loss is sustained. Same loss, same bracket: $16,000.
Qualification comes down to four checks: the stock was issued directly to your client, the corporation took in no more than $1,000,000 for its stock, the shares were paid for with money or property, and the corporation passes an active business test. Below, you get each test, where the loss goes on the return, and the records to collect at issuance.
Section 1244 covers the loss side of a startup investment. The gain side is covered in Qualified Small Business Stock (QSBS) and the 83(b) election.
Section 1244 rewards investors who fund small domestic corporations. When a qualifying holder sells the stock at a loss or it becomes worthless, Section 1244(a) treats the loss as ordinary instead of capital. Ordinary losses offset any income, while capital losses only offset capital gains plus $3,000 a year.
There is a second benefit worth raising with your client. Section 1244(d)(3) treats the ordinary loss as attributable to a trade or business when you compute a net operating loss, so non-business income does not limit it. If the loss pushes your client below zero for the year, the excess becomes an NOL carryforward.
The provision covers individuals and partnerships. Corporations are out, and Section 1244(d)(4) excludes trusts and estates, so a trust or an S corporation holding stock in a failed company takes a capital loss even on stock that would otherwise qualify. For more on how trust structures change tax treatment, see grantor vs. non-grantor trusts and their key differences.
Three parties have to pass their own tests: the stockholder, the corporation, and the transaction.
The stockholder must be an individual or a partnership. For a partnership, the loss passes to partners who held their interest when the stock was issued and continuously until the loss, and the limit applies to each partner separately.
Check original issuance first. The shares must have come from the corporation itself, not from another shareholder, a broker, a gift, or an estate.
The issuer must be a domestic corporation and a "small business corporation" under Section 1244(c)(3). That means the money and the adjusted basis of property it received for stock, as a contribution to capital, and as paid-in surplus did not exceed $1,000,000 when the stock was issued.
Two details change the arithmetic:
The corporation must also pass the active business test in Section 1244(c)(1)(C). For the five most recent tax years ending before the loss (or its whole life, if shorter), more than 50% of aggregate gross receipts must come from sources other than royalties, rents, dividends, interest, annuities, and sales or exchanges of stock or securities.
The waiver is where most failed startups land. Under Section 1244(c)(2)(C), the test does not apply if the corporation's deductions (other than net operating loss and dividends received deductions) exceeded its gross income for the period. A company that spent its capital without much revenue usually qualifies for the waiver.
The stock must be issued for money or other property, per Section 1244(c)(1)(B). Property excludes stock and securities, so a stock-for-stock swap does not qualify, and neither does stock issued for services.
This comes up in IRC Section 351 transactions: a property contribution can qualify, but shares received for services or for other stock cannot.
The annual cap depends on your client's filing status in the year of the loss, per Section 1244(b).
The joint limit is one combined figure, not $100,000 per spouse. If one spouse holds the stock and takes a $120,000 loss, $100,000 is ordinary and $20,000 is capital.
Filing status in the year of the loss controls, not the year of issuance. Anything above the cap flows through Schedule D and the Section 1211(b) limit: capital gains first, then $3,000 a year against ordinary income.
To see the cap work, take a single filer who paid $80,000 for Section 1244 stock in a company that became worthless in 2026. Under Section 1244, $50,000 of the loss is ordinary and offsets wages or consulting income. The other $30,000 is a capital loss: with no gains, the filer deducts $3,000 in 2026 and carries forward $27,000. On a joint return, the full $80,000 would have been ordinary.
Section 1244(a) allows the ordinary loss only for stock issued to the individual or partnership claiming it. Four common situations break that rule, and each one turns the loss into a capital loss.
An heir receives the shares from the estate, not from the corporation, so the issuance requirement fails even when the parent's shares met every other test. The stepped-up basis under Section 1014 sets the size of the loss but not its character. For more on how inherited assets are treated, see estate planning and tax strategies for wealth preservation.
A donee also receives the shares from a person, not from the corporation. The ordinary loss stays with the original holder, who keeps it by holding the shares or selling them, and loses it by giving them away.
Buying shares from an existing shareholder does not qualify, even in a private deal with a founder, because the corporation never issued those shares to the buyer. This catches investors who join a company after the first round and anyone who buys out a co-founder. The shares can be perfectly good stock and the loss is still capital.
Section 1244(c)(1)(B) requires the stock to be issued for money or other property. Founder shares granted for work are payment for services, so they fail even when the corporation is tiny and meets every other test. If a founder wants Section 1244 treatment on their own shares, those shares have to be paid for with cash or property.
The $1,000,000 limit is cumulative across every round. Each dollar of money and each dollar of adjusted basis of property received for stock counts.
Say a corporation raises $600,000 in a first round and $500,000 in a second. The first round qualifies. The second crosses the limit, but the corporation does not lose the whole round: under Regulation 1.1244(c)-2(b), it can designate which shares in that issuance are Section 1244 stock, up to the $400,000 that still fits.
The designation has to be made, and recorded, at the time. If your client holds shares from several rounds, trace which ones were issued under the limit, using share certificates, board resolutions, and subscription agreements.
Both sections show up in startup conversations, and one of them changed in 2025. Pub. L. 119-21 (signed July 4, 2025) rewrote several Section 1202 rules for stock acquired after that date, so the table lists both versions.
One issuance can satisfy both sections. If the company succeeds and your client holds long enough, Section 1202 can exclude the gain. If it fails, Section 1244 supplies the ordinary loss.
For clients forming a company, plan for both at formation: keep aggregate capital under $1 million, keep gross assets within the Section 1202 limit, and issue the stock for money or property.
No election or filing designates Section 1244 stock, and no box on a return marks it at issuance. Regulation 1.1244(e)-1(b) requires records that distinguish the Section 1244 shares from other stock, and if the shares later fail, your client carries the burden of proving they qualified.
Build the file at issuance, and include these five records:
Without these records the IRS can recast the whole loss as capital. The file does not need to be elaborate, but it has to exist before the loss.
If you want to confirm a qualification point against the Code and regulations, Bizora answers Section 1244 questions with citations to Section 1244 and Regulation 1.1244, so you can check the source and move on. There is a 7-day free trial, no credit card required.
Report the ordinary portion on Form 4797, Part II, not directly on Schedule D. On the 2025 form it is line 10. The 2026 draft form renumbers it to line 11, so check the line number on the form you are filing.
The same re-characterization logic shows up with depreciation recapture under Sections 1245 and 1250, where gain turns into ordinary income.
Most lost claims trace back to one of these six errors.
The qualifying facts have to exist at issuance, and so do the records that prove them. A resolution drafted after the stock goes worthless carries little weight.
Later rounds push the total over the limit, and only shares issued or designated within it qualify. Track the running total from the first issuance.
Sweat equity does not count as money or property, so those shares fall outside Section 1244 from the start.
The original issuance rule rules both out, whatever the shares were worth when they changed hands.
The ordinary portion belongs on Form 4797, Part II. Only the excess over the cap goes through Form 8949 and Schedule D.
A holding company with mostly passive income fails Section 1244(c)(1)(C) unless the deductions waiver applies.
Section 1244 is one of the few places where the Code hands a failed investment real value: a deduction against ordinary income instead of $3,000 a year. The tests are specific, and every one of them is decided at issuance: capital under $1 million, stock issued for money or property, an active business or the deductions waiver, and your client as the original holder.
For clients who found, fund, or advise startups, raise it when the stock is issued. Solo and small-firm practitioners can run these questions through Bizora or check pricing first.
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Start Free TrialOnly up to the cap. Section 1244(b) limits the ordinary deduction to $50,000 a year, or $100,000 on a joint return. Anything above that is a capital loss. A $150,000 loss on a joint return gives $100,000 of ordinary deduction and a $50,000 capital loss, which offsets capital gains plus $3,000 of ordinary income a year.
No IRS filing or election is needed. The corporation should adopt a board resolution designating the shares as Section 1244 stock, record the total capital received to show it is within $1,000,000, and keep proof that the shares were issued for money or property. If a later issuance crosses the limit, the resolution should designate which shares qualify.
A capital loss offsets capital gains plus $3,000 of ordinary income a year, with the rest carried forward. A Section 1244 loss offsets any income, including wages and business income, up to the annual cap. It also counts as a business loss for net operating loss purposes under Section 1244(d)(3), and no holding period applies.
Married filing jointly gets one $100,000 cap under Section 1244(b), whether one spouse or both hold the stock. A separate return gets $50,000. Filing status in the year of the loss controls, not the year of issuance. If one spouse holds all the stock, filing jointly doubles the available ordinary loss.
Report the ordinary portion on Form 4797, Part II (line 10 on the 2025 form), with "Losses on Section 1244 (Small Business Stock)" in column (a). Put any capital portion on Form 8949 and Schedule D. Attach a statement showing how you computed the allowable ordinary loss, as the Form 4797 instructions direct.
Yes, if the S corporation meets the tests. An individual who received stock directly from an S corporation can claim the ordinary loss when the corporation is a small business corporation and passes the gross receipts test or the waiver. A corporation or trust that holds the stock cannot, because Section 1244 is limited to individuals and partnerships.
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