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considered calculations

Deducting loss requires
considered calculations

Remember that great stock tip you got from your Uncle Jim a few years ago? He convinced you to invest in that little start-up company that was going to make you rich. Unfortunately, once you invested, the news went from bad to worse–and now you’ve stopped hearing from the company. You long ago wrote off the investment (not to mention Uncle Jim’s advice) mentally, but when can you write it off actually on your tax return?
There are some very specific requirements to claim a loss deduction for worthless securities, and those requirements sometimes can trap the unwary.
The two major requirements are: (1) that the stock be “worthless,” and (2) that you deduct the loss in the year that the stock became worthless.
The first requirement is simply an extension of the general tax principle that gain or loss is not realized until there has been a “realization event”–normally a sale of the stock. Until such an event occurs, any value decrease does not give you a loss that you can take on your tax return.
This is not always bad news, because the flip side of the rule is that gains from those investments you picked without Uncle Jim’s help are not recognized either, until triggered by an identifiable event.
Worthless stock, however, falls under one of the few exceptions to this rule. If stock truly is worthless, you cannot sell it. Thus, if you are able to prove its worthlessness, you can treat the stock, even though you continue to own it, as if you sold it for nothing. You can claim a loss (usually a long-term capital loss) for the amount you paid for the stock.
Proving worthlessness, however, is not always easy, and the courts have struggled with the concept. Just because a corporation’s financial statements show insolvency, for example, does not mean it is worthless. Many start-up companies are in this position when they borrow money to develop a new business, but may be quite valuable once they come to market. Companies in this situation whose products have been tried in the market and failed, however, may well already be worthless.
In addition to balance-sheet insolvency, the courts look for other indications of worthlessness. It may be something as obvious as a complete halt to operations or the filing of a bankruptcy petition. It may be as subtle as an argument that balance-sheet insolvency reflects true worthlessness because the business’ prospects are not good. Whatever the economic arguments, it is the taxpayer’s burden to prove worthlessness.
The second requirement is that the loss be deducted in the year in which the security becomes worthless. This test really has two elements: In order to prove that a security became worthless this year, you must prove both that it had some value at the beginning of this year, and that it had no value by the end of the year. This creates an additional burden for the taxpayer.
The real taxpayer trap in this set of rules is waiting too long to claim the deduction.
Let’s go back to Uncle Jim’s investment: The company has been stumbling along for years, and you’ve lost interest; you can’t remember exactly when you stopped hearing from them. But since you just filed your 1994 tax return and are interested in getting more deductions for this year, you do a little investigating and find out that the company has declared bankruptcy. You therefore resolve to write off your remaining cost basis on your 1995 return.
Now, suppose it’s 1997. You have forgotten you even took the loss in 1995. But the Internal Revenue Service audits your return and determines that the deduction was not allowable in 1995 because the company was worthless before then: The IRS shows that the bankruptcy petition actually was filed on Dec. 30, 1993. It decides the stock became worthless at that point and disallows your deduction for 1995.
Fine, you say: I’ll take the deduction in 1993 and file an amended return. Unfortunately, the IRS responds that the 1993 tax return cannot now be amended. The statute of limitations has passed. It looks as though you have lost the deduction forever.
Luckily, there is a special statute of limitations that gives the taxpayer extra time to claim a deduction for worthless securities and certain other items. Nonetheless, the lesson to be learned from this story is that the deduction for a worthless security should be claimed on the earliest return to which you think it might apply, and, if appropriate, renewed on subsequent returns.
Given the difficulties in identifying, proving and timing a deduction for worthless securities, you might be tempted to simplify the process by just selling the stock. So long as the stock has some value and you actually can sell to a third party, such a strategy makes good sense (provided you can tolerate the “I told you so” speech from Uncle Jim in the unlikely event the business actually does turn around).
With many such securities, however, it is difficult or impossible to locate a buyer. You might be tempted to try selling the stock to your brother for $1 in order to establish your loss, but, unfortunately, this strategy would not work. There are special rules that prevent the deduction of a loss on sales between related parties. Related parties for this purpose include your ancestors, siblings and descendants.
Another tempting thought is one of Uncle Jim’s creative tax-planning ideas. Since it was his idea to buy this company’s stock in the first place, he also bought some shares. What if you sell your shares to him for $1 and he sells his shares to you for $1? You both still have your investment, but Uncle Jim figures you each have sold your shares to recognize the loss for tax purposes.
Given his investment acumen, you might suspect that Uncle Jim has limited tax-planning skills. You would be right–your tax losses would be denied.
The law prevents the recognition of a loss on any security sold when you either acquire or enter into an agreement to acquire substantially identical securities within 30 days on either side of the date of your sale. Since your deal with Uncle Jim would provide for exactly that, this “wash sale” rule would deny the loss.
Losing money on a poor investment is a painful experience. Obtaining a tax deduction for this loss is little-enough solace. Even that solace, however, can be lost without careful application of the rules. If you own a security that you think is or may become worthless, do not wait to be sure. Investigate now, and take whatever steps are necessary to preserve your loss for tax purposes.
(Michael McEvoy, a partner at Harter, Secrest & Emery, specializes in tax matters.)

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