Tax
Section 1244: How Founders and Angels Turn a Failed Startup Into an Ordinary Loss
Section 1202 rewards the win. Section 1244 handles the loss, letting founders and angels deduct a failed startup as an ordinary loss, not a slow capital one.
By 409.AI Team - 2026-08-12
# Section 1244: How Founders and Angels Turn a Failed Startup Into an Ordinary Loss
Every founder learns about Section 1202 the moment a big exit looks possible. It's the qualified small business stock rule, the one that can wipe out federal tax on millions in gains. Almost nobody learns about its mirror image until it's too late to use it. Section 1244 is the rule for the other outcome, the one where the company doesn't make it, and it can turn a stone-cold capital loss into an ordinary deduction against your salary.
Most startups fail. That isn't pessimism, it's the base rate, and the past two years have been hard on venture-backed companies that raised at 2021 valuations and then ran out of runway. When one of those companies winds down, the equity usually goes to zero. What Section 1244 decides is how the IRS lets you use that zero.
Why "ordinary" is the word that matters
If you lose money on stock, the default is a capital loss. Capital losses first offset capital gains, and if you have none, you can deduct only $3,000 against ordinary income each year. Lose $100,000 on a failed startup with no offsetting gains and you're deducting it $3,000 at a time. That's a 33-year tax benefit for a loss you took in a single afternoon.
Section 1244 breaks that logjam. It lets an individual treat the loss on qualifying small business stock as an ordinary loss, up to $50,000 a year, or $100,000 on a joint return. Ordinary losses offset ordinary income: your W-2 wages, your consulting income, your spouse's salary. Anything above the annual cap drops back to being a capital loss and follows the normal rules.
Take an angel who put $120,000 into a startup that folds, filing jointly. The first $100,000 is an ordinary loss this year, deductible against household income at their marginal rate. The remaining $20,000 is a capital loss, available to offset capital gains or chip away at ordinary income $3,000 at a time. Without Section 1244, the entire $120,000 would sit in that slow capital-loss lane.
The company has to qualify first
Section 1244 isn't automatic. The stock has to be issued by what the statute calls a "small business corporation," and the test is about size at the moment of issuance, not at exit.
The core rule is a dollar cap. The aggregate amount of money and property the corporation has received for stock, as a contribution to capital, and as paid-in surplus, cannot exceed $1,000,000 at the time the stock is issued. That figure is written into the statute and isn't indexed for inflation, so it means the same thing in 2026 that it did decades ago. Once a company crosses the $1,000,000 line, stock issued after that point generally can't be Section 1244 stock, which is why the shares that qualify are almost always the earliest ones: founder stock and the first angel or pre-seed checks.
Two more conditions round it out. The corporation has to be domestic, and during the five most recent tax years before the loss, it has to have earned more than half of its gross receipts from an active business rather than from passive sources like rents, royalties, dividends, interest, and sales of securities. There's an exception for early-stage companies whose deductions exceed their gross income, which covers the classic startup that spent years burning cash before earning much revenue. A holding company that mostly clips coupons doesn't get Section 1244; an operating startup does.
One point founders miss: this works for both C corporations and S corporations. Section 1202 QSBS is a C-corporation-only benefit. Section 1244 doesn't care about your tax election, so an S-corp startup that would never touch QSBS can still hand its shareholders ordinary-loss treatment on the way down.
The stock has to qualify too
The shares themselves carry conditions. Section 1244 stock has to be issued for money or other property. Stock issued in exchange for services doesn't count, and neither does stock issued in exchange for other stock or securities. That's a live issue for founders who take equity for sweat rather than cash, and for advisors paid in shares.
You also have to be the original holder. The person claiming the loss has to have received the stock directly from the corporation, as an individual or through a partnership. Buy the same shares from another shareholder on a secondary and the Section 1244 character doesn't travel with them. Founder stock you bought at incorporation and filed an [83(b) election](https://409.ai/articles/the-83b-election-explained-for-founders) on is the textbook case: original issuance, paid for in cash, held from day one.
Section 1244 and QSBS are two sides of one coin
Here's the part worth internalizing. The same shares can be both Section 1202 QSBS and Section 1244 stock. Both want stock issued by a small domestic C corporation for money or property and held by the original investor. QSBS pays off if the company wins, by excluding gain; Section 1244 pays off if it loses, by accelerating the deduction. The [changes the One Big Beautiful Bill Act made to QSBS](https://409.ai/articles/qsbs-one-big-beautiful-bill-act-section-1202-changes) raised the gross-assets ceiling to $75 million and the gain exclusion to the greater of $15 million or ten times basis, and if you sell early, [Section 1045 lets you roll a QSBS gain into new stock](https://409.ai/articles/section-1045-qsbs-rollover-defer-gain-early-sale). Section 1244 is the same instinct pointed the other direction.
The overlap isn't perfect. The QSBS gross-assets test looks at $75 million; the Section 1244 test looks at $1 million and only at issuance. A company can blow past the Section 1244 cap after a Series A and still be QSBS-eligible for years. But for the founding team and the first money in, both usually apply to the same certificate.
Where valuation and records decide it
Two things sink a Section 1244 claim: missing basis and a fuzzy loss date. To deduct a loss you first need basis, which is what you actually paid, and you need a realization event, meaning a sale, an exchange, or the stock becoming genuinely worthless. Worthlessness is a factual question, and "the company stopped answering email" isn't the same as a documented wind-down. The year the stock became worthless is the year you claim it, and getting that year wrong is how founders lose the deduction to a closed statute of limitations.
Basis for stock issued for property depends on the value of what you contributed, and the $1,000,000 corporate test depends on the value of money and property the company took in. Both are valuation questions. This is where a defensible record of [fair market value at the time equity changes hands](https://409.ai/articles/409a-valuation-vs-fair-market-value) earns its keep, the same discipline a [409A valuation](https://409.ai/products/409a) brings to setting strike prices. When the win case never arrives and you're documenting a loss instead, contemporaneous numbers are what make the deduction hold up.
It also matters what your shares were entitled to. Common stock often recovers nothing after a [liquidation waterfall](https://409.ai/articles/liquidation-preferences-waterfall-common-stock-exit) pays off the preferred stack, which is precisely the situation Section 1244 was built for: real money in, nothing back.
How to claim it, and when to set it up
A Section 1244 loss goes on Form 4797 as an ordinary loss. Anything above the annual limit is a capital loss and rides along on Form 8949 and Schedule D. There's no special election to file at incorporation and no holding period to satisfy, which is one way Section 1244 is friendlier than QSBS, but you do need records proving the company met the small-business test and that you were the original holder who paid cash or property.
The practical move is to think about Section 1244 at formation, not at failure. Keep the cap table and the money-in records clean, know which early shares fall under the $1,000,000 line, and make sure founders and first investors took their stock for cash or property rather than services. None of that costs anything while the company is alive. If the company succeeds, QSBS does the heavy lifting and Section 1244 never comes up. If it doesn't, the founder who set it up right deducts a real loss against real income in the same year, while everyone who didn't is stuck deducting $3,000 at a time. Talk to your own tax advisor about your facts, but build the option in early, because it's the cheapest insurance on the cap table.