Startup investment didn’t work out? Section 1244 lets you tax deduct up to $50K per year of losses

You invest in a startup for the upside, of course. But what if things don’t go as planned?

That’s where Section 1244 comes in. It lets founders and early investors tax deduct their investment losses when a startup fails, up to $50K per year (or $100K/year for joint filers). Given the number of start-ups that fail, we’re absolutely amazed that almost nobody knows about this tax benefit, and we’re here to change that.

In this article, we explain how Section 1244 works, who qualifies, and how to use it when things don’t work out for your investment.

What is Section 1244?

Section 1244 of the Internal Revenue Code is a tax rule that helps if your startup investment doesn’t work out. It lets individual investors deduct up to $50,000 of their loss as a federal income tax deduction.

Normally, if you lose money on an investment, it counts as a capital loss, and you can only use $3,000 per year of that loss to set off against your other income, like your salary. That means, depending on the scale of your losses, you might have to wait years to get the full benefit.

But Section 1244 turns your investment loss into a much more valuable ordinary loss. You can deduct this loss against all types of income – salary, consulting income, rental income, etc. Plus, since you can deduct up to $50,000, this means you can claim a large chunk of the loss right away and reduce your tax bill in the same year.

How it works

Lisa is an angel investor. Three years ago, she invested $40,000 into a startup, receiving stock directly from the company (i.e. she invested for shares, not a SAFE).

Today, the startup has failed and the shares are worthless.

Without Section 1244:

• Lisa can only claim a capital loss, which is limited to $3,000 per year against her salary or other ordinary income.
• It would take over 13 years to use the full $40,000 loss.

With Section 1244:

• Lisa can deduct the full $40,000 as an ordinary loss this year (the year the startup failed).
• Assuming Lisa’s federal tax rate is 32%, that saves her $12,800 in taxes now ($40,000 × 32%).

Essentially, Section 1244 helps Lisa get the tax deduction from her failed investment now, not slowly over time.

Who qualifies for the Section 1244 deduction?

To qualify for Section 1244 treatment, you need to meet these conditions:

✅ You must be an individual (or file jointly with a spouse): Businesses, trusts and funds can’t claim Section 1244. It’s designed to help individual investors and founders.

✅ The company must have been a ‘small business corporation’: At the time the shares were issued, the company must have received no more than $1 million in capital investment. So this usually means you invested in the first funding round or two, for most start-ups.

✅ You bought the stock directly from the company: You need to have acquired your shares in exchange for cash (or property), not by purchasing them from another investor. You also can’t have received the stock for services you’ve done.

✅ The company used the funds in an active trade or business: At least 50% of the company’s revenues must have come from active operations, not passive investments (like holding real estate or rental income). Most startups will meet this test.

Can founders benefit from Section 1244 deductions?

If you’re a founder, Section 1244 could benefit you too, but only if you invested money into the company in exchange for stock.

If you put in cash (like funding your own seed round) and the company properly issued you shares for that investment, you could qualify for a Section 1244 loss if things don’t work out.

But shares you received just for founding the company or as part of your initial incorporation of the company, don’t qualify.

When do you claim the deduction?

You can take the deduction in the year the loss becomes final, typically the year when:

• the stock becomes worthless, or
• you sell the stock at a loss

The loss is reported using Form 4797, where you input the loss in line 10 column (a) and then add the allowable loss in column (g).

If your total loss is more than the Section 1244 limit of $50,000, the remainder is treated as a capital loss and should be reported on Schedule D and Form 8949.

How do you prove your shares qualify?

The IRS doesn’t require you to file anything at the time of investment, but you’ll need to have documentation ready if you’re ever audited.

Here’s what you should keep to be safe:

• Stock purchase agreement
• Cap table from the time of the stock issuance, showing they’ve raised under $1 million
• Proof the shares were bought for cash (not services)
• Company financials showing it was engaged in an active business

You’ll also need a clear ‘loss event’ to show the stock is worthless – like the company shutting down or you transferring the shares for no value.

If you’re unsure whether the company qualified, it might be worth reaching out to the founders or the company’s accountants to verify this.

Can Section 1244 and QSBS be used together?

Yes – and this is where smart tax planning can really pay off.

If the startup succeeds, and you meet all the QSBS criteria (for example, holding your stock for over 5 years), you may qualify to exclude up to $10 million of your gains from federal tax under Section 1202.

But if the startup fails, Section 1244 may let you write off up to $50,000 as an ordinary loss, reducing your tax bill right away.

Together, QSBS and Section 1244 can offer valuable tax relief – a potentially huge benefit if things go well and a smaller one if they don’t.

What should you do next?

If you’re investing in a startup, it’s worth understanding how tax rules like Section 1244 could apply – especially if things don’t go to plan.

Here’s what you should do:

• Check if your shares qualify for Section 1244
• Collect your documentation
• Talk to a tax advisor to make sure the loss is properly recorded
• If you’re a founder whose business is struggling, you can share this article with your investors – it could help soften the blow of any losses

If you’re an early-stage angel investor, investing in companies that have raised less than $1M (and hence still qualify for Section 1244 loss relief) then you should think about demanding stock in the company immediately, rather than investing with a SAFE, when you may never get your loss relief if the company fails.

Thanks to the ease of doing a priced round on SeedLegals, it now makes sense to talk to the founders about investing via a priced round instead of a SAFE. SeedLegals offers NVCA-compliant priced rounds at a fraction of the cost of a law firm so you can get stock right from the outset.

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