Question

Suzanne is married and the sole owner of Laidlaw Corporation. When the corporation was established in 2006, she received 10,000 shares of qualified small business stock in exchange for her $100,000 investment. On four occasions, Suzanne made loans totaling $50,000 to the corporation when it had trouble paying its bills. In March 2017, Suzanne cancels the debt of $50,000 and receives 5,000 shares of qualified small business stock. In May, she sells all her stock in the corporation.
 Is Suzanne allowed ordinary loss treatment on the sale of her small business stock?

 

 

Answer 1

The question is whether the stock Suzanne receives in exchange for the cancellation of the debt qualifies as small business corporation stock. The Tax Court in John Toney Sr., TC Memo 1986-69 stated that Congress' intention in enacting the Section 1244 stock rules (i.e., qualified small business stock) was to encourage small business development by the infusion of new funds into small businesses. Therefore, if a taxpayer had their 100% owned corporation issue stock to him in exchange for canceling the debt the taxpayer owes the corporation and then he immediately sells all of their stock in the corporation, the taxpayer is subverting Congress' intent. As a result, the stock exchanged for the cancellation of debt would not be treated as qualified small business stock. 

 

Since the research problem is based on the facts of Toney, Suzanne is not entitled to an ordinary loss on the portion of the stock sale that relates to debt. In their decision, the Tax Court viewed the debt equity other than small business stock. Therefore, only a portion of the sale would qualify for ordinary loss treatment. Suzanne would have an ordinary loss as calculated below.

 

Amount realized    [$60,000 x (10,000 ÷ 15,000 shares)]                               $ 40,000

Basis                                                                                                                     (100,000)

Ordinary loss on small business stock                                                          $ (60,000)

 

Because Suzanne is married, she can deduct the entire $60,000 ($100,000 limit for married taxpayers) as an ordinary loss. The remaining $20,000 ($60,000 - $40,000) of the sale proceeds would be used to calculate her loss on the sale of her recently acquired shares of stock. 

 

Amount realized    [$60,000 x (5,000 ÷ 15,000 shares)]                    $ 20,000

Basis                                                                                                          (50,000)

Capital loss on stock                                                                            $ (30,000)

 

If Suzanne has no other capital gains or losses she can deduct only $3,000 of the loss in the current year.

If Suzanne has no other capital gains or losses she can deduct only $3,000 of the loss in the current year.