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Claiming a Loss for Worthless Securities
By Kaye A. Thomas
Updated February 10, 2009
Claiming a loss from worthless securities.
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It isn't enough to show that your stock was entirely worthless in the year you claimed your deduction. You also have to show that it was not entirely worthless in the preceding year. You aren't allowed to choose which year you claim the loss. You have to claim it in that single, unique year in which the stock changed from being almost-but-not-quite-worthless to utterly-without-doubt-worthless.
As a general rule, you need an "identifiable event" that establishes the worthlessness of the stock. Bankruptcy can qualify — it appears that old WorldCom shares became worthless when the company (now MCI) came out of bankruptcy in April 2004, because the court's ruling extinguished all rights of the former shareholders — but stock can retain some value even during and after a bankruptcy. You may need another event that establishes zero value for your shares, such as liquidation of the corporation or events indicating it has gone out of business with no assets left to distribute.
You may find yourself in a situation where it simply isn't clear whether your shares continue to have any value. You don't know whether to claim your loss this year or wait for a sign from the heavens. There are two pieces of standard advice for people in this situation, although neither one gives a great solution.
One is to try to sell the shares, perhaps to a cooperative broker, as described earlier. You may not find a way to do that, or the cost of doing it may be more than you want to pay. And you aren't necessarily home free even if you succeed. Technically, if the shares became worthless in an earlier year (before you sold them), you're required to claim the loss in that earlier year, and the loss you claimed on the sale of the shares can be disallowed.
The other standard piece of advice is based on a frequently quoted opinion by a sympathetic judge. Noting the taxpayer's dilemma, the judge wrote that the only safe practice would be "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 for those years." (Young case, 2d Cir. 1941). Apparently you would "renew the claim in subsequent years" only if the IRS disallowed the earlier claim, since you can't double claim the loss. In any event, the special statute of limitations for this type of loss (see below) takes some of the pressure off, so it probably isn't a good idea to claim the loss in a year when it may seem possible, but highly dubious, that the stock has become worthless.
Nowadays we can search the Internet for information about companies. If the stock is no longer listed on an exchange, check for a pink sheet listing or other indication that the shares still have value. Ideally, you want to document three things:
At long last, in 2008, the Treasury adopted regulations saying you can establish the worthlessness of securities by abandoning them. The regulations do not explain the steps that would constitute abandonment, but it seems reasonably clear that gifting or donating securities is not the same as abandonment: you have to give up all rights to the shares, including the right to determine who would enjoy the benefit if they somehow recovered value.
Note also that the regulations say abandonment itself doesn't create the loss; instead, it merely establishes worthlessness. That means you're still playing within the rules for worthless securities. The date of your loss is the last day of the taxable year in which the abandonment occurs, not the date of the abandonment. Also, you can't claim an ordinary loss when abandoning a security if you would have a capital loss under the usual rules for worthless securities.
When you're ready to claim the loss, you have to show it on Schedule D as a capital loss.* You can't claim a theft loss, for example, on the theory that the stock became worthless because the executives were a bunch of crooks — even if that's true.
The amount of the loss is determined by your basis for the shares. You may have seen the stock go sky high before it sank into oblivion, and that can leave you feeling like you lost a lot more than the amount you paid for the shares. You can't include that unrealized profit in the amount of your deduction.
You have to report the loss as if you sold the shares for zero dollars on the last day of the taxable year. That's true even if the event that establishes worthlessness occurs earlier in the year.
* There are limited exceptions under which losses on certain small business shares can be treated as ordinary losses rather than capital gains.
In a pinch, you can amend a prior year return to claim the loss. Recognizing the difficulty of determining which year to claim the deduction, Congress provided a special seven-year limitation period for reporting a loss from worthless securities — more than double the usual three-year period. If you're just now realizing that some of your shares became worthless four or five years ago (or six or seven), you still have time to amend your return to claim the loss. The clock runs out seven years after the due date of the return for the year the stock became worthless.
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