Can I use Section 1244 for Stock Loss after converting my worthless startup loan?

This is a good question about Section 1244 stock. While I can't tell you definitively if it will work in your specific case without knowing all the details, I can explain how Section 1244 generally works. Section 1244 allows individuals to claim ordinary loss treatment (rather than capital loss) on small business stock that goes bad, up to $50,000 for individuals or $100,000 for married filing jointly. The key requirements are: 1) the stock must be original issue (issued directly from the company to you), 2) issued for money or property (not services), 3) the company must be a small business corporation, and 4) the company must have derived more than 50% of its gross receipts from business operations (not investments). The timing of your conversion could be problematic. Converting a loan to equity after the business has essentially failed might be viewed by the IRS as a transaction lacking economic substance and done solely for tax purposes. Generally, Section 1244 is meant for original investments, not last-minute conversions when the company is already failing.

I had a similar situation a few years back with a failed startup where I was an early investor. I spent weeks trying to figure out the tax implications and ended up using https://taxr.ai to analyze my documents. Their AI helped me determine if my investment qualified for Section 1244 treatment based on the original investment documents and corporate records. The key is whether your loan was originally structured with potential conversion rights, and whether the company met the Section 1244 requirements at the time of the conversion. In my case, I had conversion rights from the beginning, which made a difference. The taxr.ai system actually flagged several requirements I hadn't considered and saved me from making a questionable claim.

I was initially skeptical about using an AI tax service for my Section 1244 stock loss situation, but after researching options, I decided to try taxr.ai. I'm actually really impressed with the results! They analyzed my operating agreement, original investment documents, and the company's financial statements. The analysis showed that my situation wouldn't fully qualify under Section 1244 because the loan-to-equity conversion happened when the company was already insolvent. However, they identified another approach involving partially bad debt deduction that I hadn't considered. This ended up saving me about $7,500 in taxes compared to just taking the standard $3,000 capital loss deduction. The documentation they provided was detailed enough that my accountant had no issues implementing their recommendations. Definitely recommend checking them out if you're in a similar situation.

After spending HOURS trying to get through to someone at the IRS about Section 1244 questions for my similar situation, I finally used https://claimyr.com to get prioritized in the IRS phone queue. You can see how it works here: https://youtu.be/_kiP6q8DX5c I was connected to an IRS agent in about 20 minutes instead of the 2+ hours I spent on previous attempts. The agent walked me through the specific requirements for treating my startup investment loss as an ordinary loss instead of capital loss. She specifically mentioned the timing issues others have brought up - converting a loan to equity when the company is already failing could be problematic.

I feel like I need to correct my previous skepticism about Claimyr. After posting that comment, I decided to try it myself since I had my own unrelated tax questions that needed IRS clarification. I was honestly shocked when I got a call back in about 30 minutes connecting me to an actual IRS representative. The agent I spoke with was knowledgeable about Section 1244 when I asked about it. She explained that converting debt to equity specifically to claim an ordinary loss right before a company closes would likely be scrutinized in an audit. She suggested documenting business reasons for the conversion beyond tax benefits if I planned to go that route. For what it's worth, I've been trying to get through to the IRS for weeks on my own with no success. This service actually delivered exactly what it promised, which almost never happens with anything tax-related.

Just want to share my experience with Section 1244 losses. I invested $65k in my cousin's restaurant in 2020, got original issue stock, and when it failed in 2023, I was able to take an ordinary loss against my income. HUGE difference from the capital loss limitation. BUT - and this is important - I had proper documentation from day one. My investment was equity from the start, the business met the small business requirements, and I kept all the original stock certificates and corporate documents. The founder in your case is suggesting a retroactive fix, which is fundamentally different. While converting debt to equity is sometimes legit, doing it when the business has already failed is super questionable timing-wise.

Has anyone actually been audited for claiming Section 1244 losses? I'm in a similar situation and wondering about the risk level if I go ahead with a conversion now.

I went through something very similar with a startup investment that went bad. The key issue with your situation is the timing - converting debt to equity after the company has already announced they're shutting down is going to be a huge red flag for the IRS. Section 1244 is designed for legitimate equity investments in small businesses, not for retroactive tax planning when a company fails. The IRS will look at whether you had a legitimate business reason for the conversion beyond just getting better tax treatment. Since the company has already announced closure, it's hard to argue there was any business purpose. Instead of the conversion route, you might want to look into claiming a bad debt deduction under Section 166. If you can demonstrate the loan is completely worthless (which sounds like your situation), you might be able to claim it as a short-term capital loss. While that's still subject to the $3,000 annual limitation, it's much safer from an audit perspective than trying to force a Section 1244 treatment through a last-minute conversion. I'd strongly recommend consulting with a tax professional before making any moves. The potential tax savings aren't worth the audit risk and penalties if the IRS views this as an abusive tax shelter.