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