Background: Prior to the 2010 Tax Relief Act, the estate-tax exemption gradually increased from its previous high of $1 million in 2001 to $3.5 million in 2009, before the estate tax was effectively repealed for 2010 only. These changes were coordinated with other provisions in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), such as reductions in the estate-tax rates and modified “carryover basis” rules.

The new law reinstates the estate tax repealed by EGTRRA, but also allows a $5 million exemption for decedents dying in 2011 and 2012. (The IRS recently announced that the inflation-adjusted exemption for 2012 is $5.12 million.) In addition, exemptions are portable between spouses, so the estate of a surviving spouse may be able to use a portion of the unused exemption from the first spouse to die.

A new notice from the IRS clarifies the portability rules. Significantly, an estate that wants to transfer the unused estate-tax exclusion of a deceased spouse to a surviving spouse must file an estate-tax return, but will not need to make an affirmative election. The estate of the spouse will be considered to have made the portability election as long as it files a timely estate-tax return. In the new notice, the IRS also emphasized that the estates of decedents dying before 2011 cannot transfer an unused exclusion amount.

Note that an estate of a decedent dying in 2011 with assets under $5 million would not owe any estate tax and would not normally file an estate-tax return. However, under the new notice, these estates must file the return to benefit from the portability provision, even if no estate tax is owed. Normally, the return is due nine months after the date of death. An executor can request a six-month extension.

The 2010 Tax Relief Act also requires the estate making a portability election to compute the deceased spouse’s unused exclusion amount. Until the estate-tax return is revised, the IRS says that simply completing the estate-tax return will satisfy this requirement. If the executor of a small estate does not want to make a portability election, he or she does not have to file an estate-tax return. If a return is otherwise required, the executor should follow the IRS instructions. Finally, the IRS indicated that it will be issuing regulations on implementing the portability provisions.

Caution: The rules in this area are subject to change after 2012. Contact an experienced estate-tax professional, such as Faw Casson’s Regina Montagna, for further guidance.

Background: In the normal course of events, a shareholder treats a loss from a failed business venture as a capital loss for tax purposes. The loss may be used to offset any capital gains realized during the year plus up to $3,000 of highly taxed ordinary income. Any excess loss is carried over to future years.

Therefore, it may take a long time to write off large investment losses. For example, say that a taxpayer incurs a $50,000 loss from a business venture and expects to have an offset of $10,000 a year for the foreseeable future. It could take five years to recover the full tax benefit of the loss.

Conversely, Section 1244 allows the taxpayer to claim a bigger deduction on a loss from a small-business investment. The loss is completely deductible against ordinary income, after offsetting capital gains, within an annual limit. A single filer can deduct up to $50,000 of losses from Section 1244 stock in one year. The annual limit for joint filers is $100,000.

To qualify for this special tax treatment, these four key requirements must be met:

1. The corporation must issue the stock directly to the shareholders. In other words, a shareholder cannot acquire the stock from another taxpayer and deduct a loss against ordinary income.

2. The stock must be acquired in exchange for cash or property contributed to the corporation. For instance, a shareholder cannot receive the shares as compensation for services performed.

3. The stock must be issued by a “small-business corporation.” For this purpose, a small-business corporation is defined as a corporation with capital of $1 million or less.

4. The corporation must be an actual operating company. During the past five years, the corporation must have received less than 50% of its gross receipts from rents, royalties, dividends and other investment income. If the corporation is less than five years old, this test applies to those years it has been in existence.

Note that Section 1244 may be applied to both common and preferred shares of stock. Furthermore, this tax protection is not limited to investments in C corporations. An S corporation may issue Section 1244 stock if it qualifies under the tax rules.

Final words: Do not confuse this form of tax protection with other tax breaks for “qualified small business stock” (QSBS). For QSBS acquired during certain time periods, an investor who sells the stock may exclude a portion of the gain, or all of the gain in some cases, from tax. Obtain more details regarding sale of QSBS.