Worthless Securities

March 13, 2024

7541 / How is a shareholder taxed when stock or other securities are abandoned?

<div class="Section1">The IRS issued regulations concerning the availability and character of a loss deduction under IRC Section 165 for losses sustained from abandoned securities. The term “worthless security” includes a security that is abandoned and that otherwise satisfies the requirements for a deductible loss (under IRC Section 165). If the abandoned security is a capital asset (and not a worthless security of certain affiliated corporations), the resulting loss is treated as loss from the sale or exchange of a capital asset on the last day of the taxable year. To abandon a security, a taxpayer must permanently surrender and relinquish all rights in the security and receive all consideration in exchange for the security. All facts and circumstances must be considered to determine whether the transaction is properly characterized as an abandonment rather than another type of transaction, such as an actual sale or exchange, a contribution to capital, a dividend, or a gift. The regulations apply to any abandonment of stock or other securities after March 12, 2008.<a href="#_ftn1" name="_ftnref1">1</a><div class="Section1"> The courts may intervene in order to recharacterize a resulting loss from the abandonment of securities as a capital loss or an ordinary loss, if the circumstances warrant. For example, in Pilgrim’s Pride v. Commissioner,<a href="#_ftn2" name="_ftnref2">2</a> because the transaction was deemed to be a sale or exchange of capital assets under IRC Section 1234A, the Tax Court disallowed a taxpayer’s ordinary loss claimed upon its surrender of securities, finding instead that the surrender gave rise to a capital loss subject to the loss limitations of IRC Sections 1211 and 1212. The Fifth Circuit, however, disagreed and reversed the Tax Court decision. In Pilgrim’s Pride, the taxpayer rejected an offer to purchase its securities, finding that a greater tax benefit could be obtained by abandoning the securities instead. The taxpayer abandoned the securities and claimed an ordinary loss of nearly $100 million. The Tax Court found that Section 1234A, which treats gain or loss arising from the cancellation or other termination of a right or obligation which is a capital asset as gain or loss resulting from the sale or exchange of that asset, applied. The Fifth Circuit agreed with the taxpayer’s argument that Section 1234A applies only to a contractual or other derivative right to property, rather than to inherent property ownership rights. In so deciding, the Fifth Circuit rejected the Tax Court finding that Section 1234A applies to property rights inherent in intangible property, such as securities, as well as any derivative contractual rights. Therefore, the taxpayer was required to treat the loss as an ordinary loss because Section 1234A does not apply to the abandonment of capital assets under the Fifth Circuit’s reasoning. The Fifth Circuit also rejected the argument that IRC Section 165(g) requires the loss to be treated as a capital loss, holding instead that Section 165(g) applies only to worthless securities and that the securities at issue in this case were not worthless when they were abandoned.<a href="#_ftn3" name="_ftnref3">3</a> Special rules apply in the case of a short sale of property that becomes substantially worthless<a href="#_ftn4" name="_ftnref4">4</a> (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7525">7525</a>). See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="702">702</a> for a detailed explanation of the tax treatment of capital gains and losses. </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   Treas. Reg. § 1.165-5; TD 9386, 73 Fed. Reg. 13124 (3-12-2008). <a href="#_ftnref2" name="_ftn2">2</a>.   141 TC No. 17 (2013). <a href="#_ftnref3" name="_ftn3">3</a>.   Pilgrim’s Pride Corp. v. Comm., 779 F.3d 311 (2015). <a href="#_ftnref4" name="_ftn4">4</a>.   IRC § 1233(h)(1). </div></div>

March 13, 2024

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

<div class="Section1">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.<a href="#_ftn1" name="_ftnref1">1</a> (But special rules apply to certain small business and small business investment company stocks.)<a href="#_ftn2" name="_ftnref2">2</a></div> <div class="Section1"> 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.<a href="#_ftn3" name="_ftnref3">3</a> The investor must also be able to show that the security had some intrinsic or potential value at the close of the prior year.<a href="#_ftn4" name="_ftnref4">4</a> 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.”<a href="#_ftn5" name="_ftnref5">5</a> In determining whether a security is, in fact, worthless, any potential future value must be considered.<a href="#_ftn6" name="_ftnref6">6</a> (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.<a href="#_ftn7" name="_ftnref7">7</a> 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.<a href="#_ftn8" name="_ftnref8">8</a> 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.<a href="#_ftn9" name="_ftnref9">9</a> 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.<a href="#_ftn10" name="_ftnref10">10</a> Capital loss treatment will be allowed only to the extent that the loss is not compensated for by insurance or otherwise.<a href="#_ftn11" name="_ftnref11">11</a> 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.<a href="#_ftn12" name="_ftnref12">12</a> 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.<a href="#_ftn13" name="_ftnref13">13</a> 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.<a href="#_ftn14" name="_ftnref14">14</a> In Georgeff v. United States,<a href="#_ftn15" name="_ftnref15">15</a> 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. </div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC §§ 165(g), 165(f); Treas. Reg. § 1.165-5(c). <a href="#_ftnref2" name="_ftn2">2</a>. IRC §§ 1243, 1244; see also Crigler v. Comm., TC Memo 2003-93, aff’d per curiam, No. 03-1861 (4th Cir. 2004). <a href="#_ftnref3" name="_ftn3">3</a>. Treas. Reg. § 1.165-1(b); Boehm v. Comm., 326 U.S. 287 (1945); see also Bilthouse v. U.S., 553 F.3d 513 (7th Cir. 2009). <a href="#_ftnref4" name="_ftn4">4</a>. Dunbar v. Comm., 119 F.2d 367 (8th Cir. 1941). <a href="#_ftnref5" name="_ftn5">5</a>. Young v. Comm., 123 F.2d 597 (2d Cir. 1941). <a href="#_ftnref6" name="_ftn6">6</a>. Rev. Rul. 77-17, 1977-1 CB 44. <a href="#_ftnref7" name="_ftn7">7</a>. Treas. Reg. §§ 1.165-1(b), 1.165-5(c). <a href="#_ftnref8" name="_ftn8">8</a>. FSA 200226004. <a href="#_ftnref9" name="_ftn9">9</a>. See Rendall v. Comm., TC Memo 2006-174, citing Morton v. Comm., 38 BTA 1270 (1938), aff’d, 112 F.2d 320 (7th Cir. 1940). <a href="#_ftnref10" name="_ftn10">10</a>. IRC § 165(b); Treas. Reg. § 1.165-1(c). <a href="#_ftnref11" name="_ftn11">11</a>. IRC § 165(a). <a href="#_ftnref12" name="_ftn12">12</a>. IRC § 165(g)(1). <a href="#_ftnref13" name="_ftn13">13</a>. See DeLoss v. Comm., 28 F.2d 803 (2d Cir. 1928), cert. den., 279 U.S. 840 (1929); Rand v. Helvering, 116 F.2d 929 (8th Cir. 1941), cert. den., 313 U.S. 594 (1941); Heiss v. Comm., 36 BTA 833 (1937), acq. <a href="#_ftnref14" name="_ftn14">14</a>. IRC § 6511(d)(1). <a href="#_ftnref15" name="_ftn15">15</a>. 2005-2 USTC ¶ 50,585 (Fed. Cl. 2005). </div>