Your corporation may need a cash infusion to sustain its operations. Instead of seeking new investors or a loan from a commercial lender, you may put the money in yourself. Make sure that you add these new funds in a tax-advantaged way.
Section 1244 Stock
If your business is incorporated, aim for Section 1244 stock status when contributing additional capital. This will allow you to claim a capital gain if you sell your stock at a profit, or you can claim an ordinary loss of up to $50,000 ($100,000 on a joint return) if you sell at a loss or the business goes under. (Losses in excess of this limit generally are treated as capital losses). Note: Stock in both a regular C corporation as well as an S corporation can qualify as Section 1244 stock.
To qualify, all of the following qualifications must be met:
- The stock must be issued in exchange for cash or property. Stock acquired by gift or inheritance, by a purchase from another shareholder, or in exchange for services doesn't qualify.
- Total capital contributions to the business cannot exceed $1 million. So if the business has already received $700,000 for stock already issued, then only $300,000 in additional capital will support Section 1244 stock treatment.
- The corporation must be an operating company. This means that the business derives its revenue primarily from sales for the five years preceding the loss (or the time the corporation has been in business if less than five years). It cannot receive more than 50% of its gross receipts from passive income sources, such as rentals, royalties, dividends, interest, or capital gains from the sale or exchange of securities.
- Required records are maintained. These records show that each of the above requirements has been met (i.e., the stock was issued in exchange for cash or property, the amount paid for the stock, the capitalization of the corporation, and the sources of revenue for the corporation).
If you own an S corporation, consider lending funds rather than contributing to capital. Loans you make to the business can increase your basis for purposes of deducting losses passed through to you, and the repayment of the principal back to you isn't taxable.
Be sure to document the loan so that the IRS does not charge that it is a capital contribution (which could cause repayment to be characterized as a taxable dividend). The appropriate corporate officer should sign a promissory note setting forth repayment terms (e.g., interest rate, dates for repayment of principal). And the corporation should carry the obligation as a loan on its books. Caution: Merely guaranteeing corporate loans from third parties will not increase your basis. But if you're called upon to honor any guarantees you've made, you can then add to your basis the amount of your payments made as a guarantor.
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