Category: Corporations
Subject: Section 1244 Stock
Title: Discussion of Applicability of Section 1244
IRC Sections: 1244
Filename: 1292.html
Date Produced: 12/95

Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com

Background
The facts are as set forth in your letter of June 14, 1995 which is incorporated by reference into this document.

Additional information and assumptions:

-XYZ was incorporated in 1983 and went bankrupt in approximately 1986.

-With respect to the initial stock issuance, I assume that the technical provisions of Section 1244 are satisfied. Generally, 1) XYZ, Inc. is a domestic corporation; (2) a majority of the total gross receipts of XYZ, Inc. for the five year period preceding the alleged Section 1244 loss were received from sources other than rents, royalties, dividends, interest, or sales or exchanges of stock or securities; (3) the stock of XYZ, Inc. is common stock and was issued (actually issued) directly to the individual(s) claiming the loss; (4) the stock of XYZ, Inc. was issued in exchange for money or other property but not for other stock or securities.

-There is no evidence that additional shares were issued with respect to the additional capital contributed to XYZ, Inc. subsequent to the initial $100,000 capitalization. In fact, all capital contributed to XYZ, Inc. after the initial $100,000 is represented on the books of XYZ as amounts loaned by shareholders, and some of the amounts (about $90,000 out of the total additional amount of $350,000) are represented by notes between XYZ and the various shareholders.

-There is no subscription or other such agreement through which the initially- issued shares of XYZ were to be paid for in installments over a period of years.

-No interest was ever paid, accrued, or imputed with respect to the additional capital contributions.

Issues
1. Is the stock issued with respect to the initial capitalization of $100,000 eligible for Section 1244 treatment?

2. Are the subsequent capital contributions so eligible?

Answers
1. It appears that the initial $100,000 contributed is eligible for Section 1244 treatment assuming the taxpayers can bear the burden of proving that the money was contributed in exchange for stock of XYZ, Inc.

2. The additional capital contributions are clearly not eligible for Section 1244 treatment.

Discussion
With respect to the first issue, there is very little to discuss. We have assumed that the technical requirements of Section 1244 are met as regards the first $100,000 contributed. If that is the case and the taxpayer's can meet their burden of proof if scrutinized, I know of no reason that Section 1244 treatment should be denied.

The conclusion with respect to the second issue is very clear.

First, in order to even raise the Section 1244 issue, one must successfully contend that the additional capital contributed to XYZ was equity capital at the risk of the business rather than debt capital as it was described on XYZ's books and in some cases memorialized by formal notes. This is a speculative matter at best. Clearly the Service could argue with some justification that the taxpayers in this case should not be allowed to benefit from hindsight; and thus, having characterized the additional capital contributions as debt, the taxpayers should be bound by that characterization.

Assume, arguendo, that the debt-equity concern could be overcome and the additional amounts of contributed capital could properly be treated as equity, not debt. There is black-letter law to prevent Section 1244 treatment in this case.

Internal Revenue Code Section 1244(d)(1)(B) provides that any increase in the basis of Section 1244 stock shall be treated as attributable to stock which is not Section 1244. Under Regulation Section 1.1244(d)-2(a), where a loss is sustained on section 1244 stock and where the taxpayer's basis in the stock has increased during the time the stock was held, the loss must be apportioned between the stock qualifying as section 1244 stock and the capital interest not qualifying as section 1244 stock. The loss apportioned to the qualifying section 1244 stock is the only portion of the loss that is treated as an ordinary loss and the remaining portion of the loss is treated as a capital loss. Regulation Secs. 1.1244(d)-2(a) and (b). The total loss is apportioned between the qualifying section 1244 stock and the non-section 1244 stock interest in the same ratio that the taxpayer's basis in the section 1244 stock bears to the taxpayer's total basis in the stock of the corporation. Regulation Sec. 1.1244(d)-2(a).

The case of J.D. Pierce, 58 TCM 865, Dec. 46,192(M), TC Memo. 1989-647, is remarkably similar to the present set of facts. In Pierce, the taxpayer advanced monies, nominally treated as debt, to his closely-held corporation. No additional shares were issued in connection with these advances. When the corporation ultimately failed and the taxpayer claimed ordinary loss treatment under Section 1244, the court rather unceremouniosuly held the taxpayer to a strict reading of the statute and regulations as regards issuance of additional shares. In other words, the taxpayer in Pierce lost the case solely because no additional shares were issued.

The statute at Section 1244(d)(1)(B) is about as clear as tax statutes ever get, and the taxpayers in this case clearly do not meet one of the requirements set forth in the statute. Moreover, Section 1244 is a relief provision, in other words the provision allows a special tax benefit to a narrowly-defined set of taxpayers. It is a major tenet of interpretation of tax rules that relief-type provisions must be strictly construed. See for example, Interstate Transit Lines v. Cmr., 319 U.S. 590, 43-1 USTC ¶9486 (USSC 1943); Malat v. Riddell, 64-1 USTC ¶9432; Cmr. v. P. G. Lake, Inc. 58-1 USTC ¶9428, 356 U. S. 260, to name just a very few cases. The theory is if Congress sees fit to bestow a benefit on a certain defined group of taxpayers, the criteria set forth by Congress in defining the group of taxpayers to whom the benefits will flow must be strictly construed.

More importantly and of much greater relevance to our specific situation is the fact that the courts have historically been extremely strict in requiring taxpayers to comply with the letter of the law in the Section 1244 area. Prior to 1978, Section 1244 required adoption of plan to issue Section 1244 stock as well as the inclusion of certain disclosure statements in various tax returns. Set forth below is an excerpt of one typical case in which the strict construction issue is discussed. I think this case throws a bright light on what the taxpayer in the present situation is up against.

Joseph P. and M. Catherine Cosgrove v. Commissioner, TC Memo. 1987-401, 54 TCM 136 (1987).

We have held that substantial regulatory compliance will suffice where the regulatory requirement does not go to the substance or essence of the statute. See Cary v. Commissioner [Dec. 26,396], 41 T.C. 214 (1963); Taylor v. Commissioner [Dec. 34,332], 67 T.C. 1071 (1977). However, this Court has always required strict compliance with section 1244 and the regulations promulgated thereunder. We have denied ordinary loss treatment for the absence of a written plan, Spiegel v. Commissioner [Dec. 28,857], 49 T.C. 527 (1968); \9/ for the failure of the plan to state a maximum dollar amount, Mogab v. Commissioner [Dec. 35,148], 70 T.C. 208 (1978); and for failure of the plan to state that stock must be issued within 2 years after the plan's adoption, Godart v. Commissioner [Dec. 29,487], 51 T.C. 937 (1969), affd. [70-1 USTC ¶9241] 425 F.2d 633 (2d Cir. 1970). In short, as we stated in Morgan v. Commissioner [Dec. 28,131], 46 T.C. 878, 889 (1966): Section 1244 being designed to provide a tax benefit to a rather limited group of taxpayers as it is, we feel that qualification for those benefits requires strict compliance with the requirements of the law and the regulations promulgated pursuant to the specific requirements therefor included in section 1244(e). See also Mogab v. Commissioner, supra at 212. The importance of complying with the record-keeping requirements of section 1.1244(e)-1, Income Tax Regs., was pointed out in Morgan v. Commissioner, supra at 892. \10/

We do not decide whether these record-keeping requirements go to the substance or essence of the statute; rather we think that strict compliance with these requirements is compelled by existing case law, the broad legislative mandate of section 1244(e), and the legislative history. Accordingly, we hold for respondent on this issue.

I think the excerpt above brings into clear focus the degree to which strict compliance is required in the Section 1244 area. Accordingly, in view of the taxpayer's clear failure in this case to comply with the requirements of the statute, it is my opinion that Section 1244 treatment is not available with respect to the additional capital contributed to XYZ.