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  Ask the tax adviser By George Saenz, Bankrate.com    

Writing off a bad business investment

Dear Tax Talk,
Two years ago I invested $20,000 in a small business my friend started (either as a corporation or S corporation). I was issued shares in exchange for the money I invested. For the last two to three months the business stopped operating, and his whereabouts are unknown. Is there a tax write-off I can use? Can I consider the investment as a capital loss?
-- Cheng

Dear Cheng,
It's a shame you lost your friend and worse yet the $20,000.

It would be helpful if you could find the accountant that the friend was using to figure out if tax returns were done. As a shareholder of the company, you could call the Internal Revenue Service if you have the tax ID number of the business and find out if it is a conventional corporation or if it made an S election.

If it made an S election and no tax return was done, it would probably be a good idea to do the return so that you can claim some or all of your loss as an ordinary loss that flows to your individual return. Depending on your percentage of ownership in the company, some or all of the $20,000 could be an ordinary loss from an S corporation that could be offset against your other income.

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If there is no S election, you may still be able to claim an ordinary loss from what's called Section 1244 loss. Section 1244 stock is stock that is originally issued by a company (as opposed to being acquired from another person) in exchange for cash. This sounds like your situation.

If you put the full $20,000 in at once in exchange for the stock, then it's likely the stock loss would qualify for Section 1244 treatment. If you put in only $5,000 for the stock you originally received and later put in another $15,000 as additional capital without receiving stock, then only $5,000 of the $20,000 would qualify for Section 1244 treatment, the remainder would be capital loss.

The company had to be an operating company and not an investment company, meaning that it can't receive more than 50 percent of its income from rents, dividends and interest.

Report a section 1244 loss on Form 4797. IRS Publication 550 discusses Section 1244 loss.

-- Posted: Jan. 11 2005

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See Also
Writing off stock losses
Taking tax advantage of a worthless stock
Tax glossary
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