★ QBI & Pass-Through Strategy

§1244: Ordinary Loss on a Failed Startup

"You wrote a $200K check into your friend's C-corp. The company died. Without §1244, you have a $200K capital loss that you'll deduct $3,000 at a time for the rest of your life. With §1244, $100,000 is ordinary loss this year. $37,000 federal refund the spring after the shutdown."

Typical Savings: $10K–$40K refund Difficulty: ★★☆☆☆ Audit Risk: Low (if set up right) Best For: Founders, angels in C-corps

The 60-second pitch

Most stock investment losses are capital losses, deductible only against capital gains plus $3,000 of ordinary income per year. A $200,000 startup loss without §1244 takes 67 years to deduct fully against ordinary income — assuming you live long enough and have no offsetting gains.

Section 1244 is a one-page rescue valve buried in the Code. For stock in a qualified small business corporation — first $1M of capital, real operating business, not a holding company — losses on sale or worthlessness get ordinary-loss treatment up to $50,000 per year ($100,000 MFJ). The first $50K/$100K of loss flows to Schedule 1 as an above-the-line deduction, NOL-eligible, deductible against W-2 wages, consulting income, or anything else.

The trick is that §1244 isn't an election made at sale — it's a structural feature of the stock at issuance. To qualify, the stock has to have been issued by a domestic C-corp (or S-corp) for cash or property (NOT services), to the original holder (not a buyer in the secondary market), at a time when total capital didn't exceed $1M, and the corporation has to have been an operating business (not investment income).

Founders who issued themselves stock and angels who wrote first checks routinely qualify without ever having heard of §1244. The win comes years later when the company fails — and the founder discovers their $200K capital loss is actually $100K ordinary + $100K capital. The first $100K is worth $37K in federal tax savings at a 37% bracket. The capital loss piece still rolls forward at $3K/year, but the bulk of the pain is taken now.

Real-world example

Jordan & Sam · Married Co-Founders · Their C-corp Failed in 2025

The backstory. In 2021, Jordan and Sam (married, filing jointly) incorporated DataLoop, Inc. as a Delaware C-corp. They contributed $200,000 in cash for 8,000,000 founder shares ($0.025/share). The corporation had no prior capital and total capital at issuance never exceeded $1M (they later raised a $400K SAFE that converted to preferred, but the founder shares are tested on their own facts at issuance). The corporation ran a real SaaS business — recurring revenue from B2B customers, never more than 10% of gross receipts from passive items. It was, in IRS terms, a Qualified Small Business Corporation (QSBC).

The wipeout. Q2 2025: DataLoop runs out of cash, can't raise a bridge, formally dissolves under Delaware law. Founders' stock is now worthless. Jordan and Sam's basis was $200,000 combined ($100K each).

The default treatment (without §1244). $200,000 capital loss from worthless stock under §165(g). Limited to $3,000/year offset against ordinary income (plus any capital gains). At their 37% combined federal + 6% state marginal, the $3K deduction is worth $1,290/year. To recover the full $200K loss against ordinary income at $3K/year would take 67 years.

The §1244 election (engineered at issuance, claimed at failure). Because the founder stock met all §1244 requirements at issuance — domestic C-corp, <$1M total capital, original holder, issued for cash, operating business — Jordan and Sam claim §1244 ordinary loss on Form 4797, Part II.

The math. $100,000 of the $200,000 loss is reclassified as ORDINARY loss (the $100K MFJ cap). The remaining $100,000 is short/long-term capital loss as normal.

The federal refund (filed spring 2026 for tax year 2025):
• Ordinary loss $100,000 × 37% federal = $37,000
• State (NJ) loss $100,000 × 6.37% = $6,370
• Capital loss $100,000 — used against $0 of capital gains this year, then $3,000/yr carry forward against ordinary income, value $1,110/yr (37%).

The result. Combined federal + state tax savings in the year of failure: ~$43,370. Plus the capital loss carryforward, which over time recovers roughly another $30K–$40K of value depending on future capital gains. The §1244 election effectively converts a 67-year drip into a same-year refund.

Ordinary loss recovered (MFJ)

$100,000

Federal + state refund (year of failure)

$43,370

The step-by-step checklist

Confirm the corporation is a Qualified Small Business Corporation (QSBC) at issuance. Domestic corporation. Total capital (money + property other than money) received as consideration for stock + paid-in surplus does not exceed $1,000,000 at the time the stock was issued. §1244(c)(3).
Confirm the stock is "§1244 stock." Issued by a QSBC, for money or property (NOT services, NOT another stock or security). Includes common AND preferred stock (post-1978 issuances). §1244(c)(1).
Confirm you're the original holder. §1244 only applies to the person to whom the corporation originally issued the stock. Buying shares in the secondary market — even directly from the founder — kills §1244 treatment for the buyer. Partnerships can hold §1244 stock and pass through to original-holder partners.
Confirm the gross receipts test for the 5 years preceding the loss. During the 5 most recent tax years ending before the loss, more than 50% of the corporation's aggregate gross receipts must have been from sources OTHER than royalties, rents, dividends, interest, annuities, and sales/exchanges of stocks or securities. (If the corporation existed < 5 years, use its full life.) This is the "operating business" test. §1244(c)(1)(C).
Keep records that prove all of the above. Original stock certificate or book entry. Cash receipt (wire confirmation, cancelled check). Corporate minutes authorizing issuance. Financial statements showing < $1M capital at issuance. Annual gross receipts breakdown for the operating test.
Recognize the loss event. §1244 ordinary loss is triggered by: (a) sale or exchange of the §1244 stock, (b) worthlessness under §165(g), OR (c) liquidation distributions. The stock has to actually have lost value — paper losses without a recognition event don't count.
Compute the loss. Loss = adjusted basis − amount realized. Adjusted basis is generally what you paid (cash) plus any property contributions (at carryover basis under §351 if applicable, but §351 contributions cap §1244 basis at the property's basis to the corporation — read §1244(d)(1)(B) carefully).
Apply the annual cap. Up to $50,000 ($100,000 MFJ) of ordinary loss per year. Excess is capital loss. The cap is per year, not per stock issuance — large losses can be spread across multiple worthlessness years (very rarely useful in practice; failure usually happens in one year).
Report on Form 4797, Part II. Ordinary loss. Flows to Schedule 1 of Form 1040. Eligible to create or increase a Net Operating Loss (NOL) for the year, which can carry forward (post-TCJA, no carryback for most NOLs).
Report any excess as capital loss on Form 8949 / Schedule D. Normal capital loss rules apply — $3,000 ordinary offset per year + capital gains offset, indefinite carryforward.
If you took early-stage investor losses too: consider whether §1202 (QSBS gain exclusion) was in play before failure, or whether the loss can also feed an NOL carryforward you can use against future spouse income or future business income. §1244 doesn't preclude §1202 — they're separate regimes.
For new corporations being formed now: document §1244 eligibility at the moment of issuance. Cheap insurance. The "Section 1244 stock plan" is a board resolution you adopt at formation that costs nothing and forecloses dispute at audit. Older boilerplate "1244 plan" requirements were repealed in 1978, but issuance documentation still matters.

IRS code & authority

IRC §1244 The statute. Establishes ordinary loss treatment up to $50K ($100K MFJ) on losses from §1244 stock.
§1244(b) The annual cap: $50K, or $100K on a joint return.
§1244(c)(1) Definition of §1244 stock: (A) issued by a domestic small business corporation, (B) issued for money or other property (not stock/securities/services), (C) issued by a corporation that meets the operating-receipts test for the 5 preceding years.
§1244(c)(3) "Small business corporation" definition — aggregate capital at the time of issuance cannot exceed $1,000,000.
§1244(d)(1)(B) Basis limitation rule for stock received in a §351 transaction — basis for §1244 purposes is capped at the property's basis (not its FMV).
§1244(d)(2) Increases in basis from contributions to capital are NOT treated as part of §1244 basis. Only the basis at issuance counts. (This is why founders sometimes lose §1244 on later capital contributions.)
§165(g) Worthless securities — establishes the recognition event for stocks that become worthless during the tax year. §1244 builds on this.
Reg §1.1244(a)-1 through §1.1244(e)-1 Operational regulations. Recordkeeping (§1.1244(e)-1) and the now-obsolete plan-adoption rules.
Form 4797 Part II Where §1244 ordinary loss is reported on the return.

Audit risk flags

Stock issued for services. Founder common shares issued in exchange for "sweat equity" or services-rendered don't qualify under §1244(c)(1)(B). Stock issued for property (including IP transferred via §351) does qualify, but cash is cleanest. Defense: Pay cash for founder stock at incorporation, even a token $1,000. Document the wire.
Capital exceeded $1M at issuance. The QSBC capital test is at the moment of issuance — but later rounds don't disqualify earlier-issued stock. Confusion is when founders issue themselves additional shares (e.g., a re-up or anti-dilution restoration) after the corporation has raised > $1M. Defense: Issue founder shares before any priced round. Document the capital ledger as of each issuance date.
Gross receipts test failure. Holding company that owned passive rental real estate alongside its operating business — passive receipts > 50%. Defense: Separate the operating business from the investment activity. Confirm the receipts breakdown each year.
Buying secondary shares. An angel who bought shares from a departing founder in 2023 thinks they have §1244 stock. They don't. Original-holder requirement is strict. Defense: Get §1244 directly from the corporation in a primary issuance. Secondary investors get §1202 if applicable, not §1244.
Worthlessness timing. Claiming the loss in the wrong year. The corporation has to be actually worthless — formally dissolved, bankrupt, or with no realistic path to value. Premature claims get bounced; late claims have SOL problems. Defense: Document the worthlessness event with corporate resolution, dissolution filing, bankruptcy petition, or formal abandonment.
S-corp shareholders. §1244 historically applied only to C-corp stock; S-corp shareholders sometimes claim it. The IRS position is that S-corp stock CAN be §1244 stock if the corporation otherwise qualifies and the shareholder is the original holder. But S-corp shareholders also have basis/pass-through losses that may already absorb most of the loss before any §1244 stock loss arises. Defense: Coordinate §1244 with §1366 basis ordering.
Recordkeeping gaps. The regs require records showing the stock qualifies. Without an issuance record, capital ledger, or operating-receipts breakdown, the IRS can deny. Defense: Keep the cap table, the receipt of payment, and annual income breakdowns from year 1.
Joint return cap misapplied. Single founder files joint with non-founder spouse and claims $100K. OK — the $100K MFJ cap applies regardless of which spouse owns the stock, as long as filing joint.

When NOT to use this

Your investment was an LLC or partnership. §1244 only applies to corporate stock. Pass-through losses already flow at ordinary rates via §1366 (S-corp) or §704(d) (partnership). No §1244 needed.
You bought the shares in a secondary transaction. Original-holder requirement excludes secondary buyers. Take §165(g) capital loss treatment and move on.
The corporation was a holding company / investment vehicle. Gross receipts test fails. Take normal capital loss.
Total capital at issuance exceeded $1M. Doesn't qualify. The $1M test is a hard line; even $1,000,001 in aggregate equity-raised capital kills it for shares issued at that round.
Your basis is small. §1244 caps ordinary loss at $50K/$100K. If you only put in $5K, the maximum benefit is $5K at your bracket — small win, paperwork still required.
The "loss" is really a gain you're trying to disguise. Some founders try to abandon clearly-still-valuable stock to claim §1244 loss. Worthlessness has to be real; the IRS readily challenges.
You can still use §1202 QSBS gain exclusion on the same stock. §1202 excludes up to 100% of GAIN on sale of QSBS. §1244 deducts LOSS. Same corporation can qualify for both regimes — but they apply to different outcomes (winners use §1202, losers use §1244). Don't confuse them at filing.

Save the proof at incorporation

PilePilot's Vault keeps your incorporation docs, cap table, capital ledger, and original stock issuance proof in one place — so when (if) the wheels come off, you have the §1244 paper trail ready. Built for small businesses who's claimed §1244 on actual returns and survived the IRS letters.

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Disclaimer. This page is educational, not tax advice. §1244 eligibility is determined at the time of stock issuance and requires careful contemporaneous documentation of the corporation's capital and operating-receipts profile. The $50K / $100K cap applies per tax year, with excess loss treated as capital loss. Worthlessness and dissolution events must be supported by formal corporate action. §1244 is frequently confused with §1202 (QSBS gain exclusion) — they are distinct regimes with overlapping but not identical eligibility rules. Work with a qualified tax professional before claiming the loss, and ideally before forming the corporation if §1244 protection is desired.