7540 / How is an investor taxed when stocks or other securities becomes worthless?

If an investor’s security—whether it be stock in a corporation or another security—becomes worthless at any time during the year, the loss is treated as a capital loss realized in a sale or exchange of the worthless security on the last day of that year.¹ (But special rules apply to certain small business and small business investment company stocks.)²

The determination as to when a security becomes worthless is often very difficult and has been the subject of extensive litigation. The investor must be able to show that an identifiable event (or events) resulting in the worthlessness occurred in the year in which the investor claims the loss.³ The investor must also be able to show that the security had some intrinsic or potential value at the close of the prior year.⁴ In fact, the determination is often so difficult that the United States Court of Appeals for the Second Circuit has said that the “only safe practice … is to claim a loss for the earliest year when it may possibly be allowed and to renew the claim in subsequent years if there is any reasonable chance of its being applicable … in those years.”⁵

In determining whether a security is, in fact, worthless, any potential future value must be considered.⁶ (Although the taxpayer would have to demonstrate that the security has no present value, the concept of present value takes into account any projected future income stream.) The security must be totally worthless; a “paper” loss on a security that is partially worthless or that has declined in value is not realized and may not be recognized until the security is actually sold or exchanged.⁷

In Field Service Advice released in 2002, the IRS discussed at length several factors relating to worthless stock including (1) the factual nature of the inquiry into the worthlessness of stock; (2) the two-part test for the worthlessness of stock, and the application of the test; (3) identifiable events in general; (4) determining worthlessness without an identifiable event; (5) timing of the loss using identifiable events; (6) liquidation as an identifiable event, and liquidation as destroying potential worth; (7) the fact that stock is not worthless simply because nothing is received for it; (8) the potential worth of (a) stock disposed of by sale, (b) the investment after the election, (c) canceled stock, and (d) surrendered stock; and (9) the potential worth because of claims for reimbursement.⁸

According to the Tax Court, the principles for establishing the worthlessness of stock in a particular taxable year are virtually identical to the principles for establishing a worthless debt. Thus, as in the case of a bad debt deduction due to the worthlessness of a debt, to sustain a worthless stock loss the taxpayer must show an absence of potential as well as liquid value by year-end.⁹

Generally, the amount of the capital loss resulting from a security’s becoming worthless is the shareholder’s tax basis in the security as of the last day of the year in which it becomes worthless.¹⁰ Capital loss treatment will be allowed only to the extent that the loss is not compensated for by insurance or otherwise.¹¹

The loss from a capital asset that becomes worthless during a taxable year is determined as if the asset were sold or exchanged on the last day of the year; thus, the taxpayer’s holding period would apparently be determined as of that date.¹²

Because of the difficulties in proving the “if” and “when” of worthlessness, it is often suggested that a security nearing worthlessness be sold to establish the loss. A loss on such a sale may nevertheless be disallowed if it can be shown that the security became worthless in a prior year.¹³

In the case of a capital loss claimed to have been sustained as a result of a security’s becoming worthless, the normal three-year statute of limitations for amending federal income tax returns is extended to seven years.¹⁴ In Georgeff v. United States,¹⁵ the taxpayers filed their 1997 tax return on September 25, 2002, identifying an alleged worthless security loss and also claiming entitlement to a refund for that loss on the same return. The taxpayers argued that the special seven-year statute of limitations should apply. Rejecting the taxpayers’ argument, the United States Court of Federal Claims stated that IRC Section 6511(d) was designed to provide protection for deductions attributable to bad debts freshly discovered or newly increased after the filing of an original tax return, not those identified before the tax return was filed. The court concluded that the taxpayers were not entitled to the benefit of an enlarged statute of limitations from three to seven years because the alleged loss based on the worthless security was known well in advance of the time that their 1997 tax return was due on April 15, 1998, and filed on September 25, 2002. Accordingly, the court dismissed the taxpayers’ complaint and granted the United States’ motion for summary judgment.