Question

Simmon is ready to retire to his rocking chair, so he says to you: “I own 500 shares of stock in Castro, INC. and I’m ready to cash out. So I’ll sell it to you for the very same $25,000 I paid for it back in 2012. And, by the way, you’ll be happy to know that it’s qualified small business stock, so you’re completely protected on the downside – if the company went under, you would get 100% tax cushion for the loss! What do you say...???” On its face, what’s wrong with this offer, and why?

Answer 1

Since the stock will be purchased from a shareholder and not the company directly, any loss incurred will not qualify as ordinary loss but as capital loss. The capital loss can be used to offset capital gain and ordinary income up to $3000. The capital loss left would have to be carried forward to the next year. Hence it is not complete protection on the downside of the invested amount as ordinary loss in excess of $3000 would not be protected.

Had the stock been purchased from the company directly then any loss on it would qualify as ordinary loss. This ordinary loss could then be used to offset capital gain and ordinary income up to $50000. This would be complete protection from the downside of the invested amount