8761 / Is a loss sustained as a result of worthless securities treated as an ordinary loss or a capital loss?

Generally, securities are classified as capital assets and any loss resulting from their disposal will receive a capital loss treatment.¹ As a capital loss, the loss is considered to have occurred on the last day of the taxable year, which may allow the conversion of a loss that otherwise would have been treated as short-term loss into long-term loss (see Q 8625 and Q 8750 for a discussion of capital loss treatment and the holding period requirement).²

Despite this, IRC Section 165(g)(3) allows domestic corporate taxpayers to treat losses sustained on worthless securities as ordinary losses if an affiliated corporation issued the securities. An “affiliated corporation” is one that meets the following ownership test:

(1)  the corporate taxpayer owns at least 80 percent of the voting stock and value of the corporation;³ and

(2)  more than 90 percent of the affiliated corporation’s aggregate gross receipts for all taxable years has been derived from sources other than royalties, rents, dividends, interest, annuities, and gains from sales or exchanges of stock and securities.

If the taxpayer is a bank which directly owns at least 80 percent of the stock of another bank, the stock will not be treated as a capital asset. Hence, any loss incurred on disposition of these stocks will be treated as ordinary loss.⁴

See Q 8762 for the special treatment of losses sustained upon the sale of certain small business stock.