8760 / When is a deduction permitted if a taxpayer owns securities that become worthless?

While IRC Section 166 does not apply to worthless securities,¹ IRC Section 165 allows a deduction for losses incurred based on ownership of securities that have become completely worthless during the year. The term “security” for purposes of IRC Section 165 includes shares of stock, stock rights or evidence of indebtedness issued by a corporation or a government.² The worthlessness of the security is a question of fact³ and the loss will be disallowed unless the taxpayer is able to furnish proof of the original cost of the security.⁴

There are no fixed rules that apply when determining whether a security is completely worthless. The taxpayer is required to make a reasonable inquiry, and what is reasonable here is based on the inquiry that a reasonable person would make in order to determine the worthlessness of the securities.⁵ Worthlessness must be determined objectively.⁶

The securities do not have to be sold to establish worthlessness,⁷ but it is insufficient to show that the securities would have no value if sold.⁸ Diminution in value is also not enough to establish worthlessness.⁹

Worthless securities also include securities that the taxpayer abandons after March 12, 2008. To abandon a security, all rights in the security must be permanently surrendered and relinquished and no consideration received in exchange for the security. All the facts and circumstances determine whether the transaction is properly characterized as an abandonment or other type of transaction, such as an actual sale or exchange, contribution to capital, dividend, or gift.¹⁰

The worthlessness of securities is generally established by a showing that an identifiable event (or series of events)¹¹ occurred, and that it is reasonably certain the event (or events) rendered the securities completely worthless. An identifiable event has been judicially defined as “… an incident or occurrence that points to or indicates a loss-an evidence of a loss. The evidence, though, may vary according to circumstances and conditions.”¹² The Board of Tax Appeals also defined identifiable events as “... such events as would clearly evidence to the person of average intelligence, under the circumstances, that no probability of realization of anything of value from this investment, by sale, liquidation, or otherwise, thereafter existed.”¹³ The identifiable event may be an actual cancellation of the debt or it may be an event the applicable entity is required, solely for purposes of reporting to the IRS, to treat as a cancellation of debt.¹⁴

The Tax Court has also held that it is reasonable to consider junior securities worthless in a case where a liquidation analysis showed there were no current profits to pay preferred (senior) securities and that there was no reasonable belief that such profits could be anticipated. In other words, the court found that it is not necessary to show that the entity issuing the securities has no value whatsoever.¹⁵