In Section 18-3c, the text explains the special treatment allowed for losses incurred on the sale or worthlessness of stock in a “small business corporation” under IRC § 1244.

Individuals A and B are 50% partners in Partnership C, and there have never been any other partners in the partnership.

On July 1, 2010, Partnership C acquired 500 shares of common stock in Corporation D in an IRC § 351 transaction. In exchange for the shares, Partnership C contributed land and a building that had an adjusted basis of $30,000 and a fair market value of $20,000 at the time of the contribution. Under the built-in loss rules described in Section 18-1f of the text, Corporation D’s basis in the land and building was its $20,000 fair market value at the time of the transaction, and Partnership C’s basis in its stock was the $30,000 adjusted basis of the land and building. The only other shareholder in Corporation D is Individual E, who acquired 500 shares of common stock in the same IRC § 351 transaction for $20,000 in cash. Currently, Partnership C and Individual E each own 600 shares of common stock in Corporation D as a result of a 20% nontaxable stock dividend declared and paid in 2018.

Since its incorporation, Corporation D has derived all of its income from the operation of a restaurant, but it has never been very successful and it has never paid a dividend. Individual E has offered to purchase Partnership C’s shares of Corporation D stock for $15,000. Individual B is in favor of the proposal. However, Individual A would like to continue to hold an investment in the restaurant, and has proposed that Partnership C distribute its shares in Corporation D to its partners. Individual A will retain her 300 shares and Individual B will sell her 300 shares to Individual E. Individual E would be willing to purchase those 300 shares for $7,500.

As we will see in Chapter 21, if Partnership C distributes 300 shares of stock each to Individuals A and B, there will be no gain or loss recognized by the partnership or the partners. Each partner will take Partnership C’s $15,000 basis in the 300 shares the partner receives. If, in the alternative, Partnership C sells 300 shares of the stock at the $7,500 price offered by Individual E, Individuals A and B will each report one-half of the loss incurred. If Partnership C then distributes the remaining 300 shares to Individual A and the $7,500 cash to Individual B, neither Individuals A nor B nor Partnership C will recognize any gain or loss on the distributions. Individual A will take Partnership C’s $15,000 basis in the stock. Individual B will simply have $7,500 in cash.

In answering the following questions, assume that there are no transactions or events that affect a shareholder’s basis in stock other than those mentioned and that none of the parties owns any other IRC § 1244 stock.

1. If Individual A’s proposal is adopted, Individual B will incur a $7,500 loss on the sale of stock to Individual E (her $15,000 basis in the stock, minus the $7,500 payment). Assuming she has no other losses, how much of her loss, if any, will receive ordinary loss treatment under IRC § 1244? Explain.

2. If, instead, Partnership C sells 300 shares to Individual E for $7,500 and distributes the other 300 shares to Individual A and the cash proceeds of the sale to Individual B, Partnership C will realize a loss of $7,500 (its $15,000 basis in the shares minus the $7,500 payment), and Individuals A and B will each have a $3,750 share of loss from the sale passed through the partnership to them.

A. Assuming Individual A has no other losses, how much of her $3,750 share of the partnership’s loss, if any, will receive ordinary loss treatment under IRC § 1244? Explain.

B. Assuming Individual B has no other losses, how much of his $3,750 share of the partnership’s loss, if any, will receive ordinary loss treatment under IRC § 1244? Explain.

3. Assume Individual A ultimately decided that she did not want to retain an investment in the restaurant, so that Partnership C sold all of its shares to Individual E for $15,000, as originally proposed. Individual E then made a capital contribution of $10,000 to Corporation D, but Corporation D failed anyway and its stock became worthless. How much of a loss did Individual E incur when the stock became worthless and how much of that loss, if any, will receive ordinary loss treatment under IRC § 1244? Explain.