Lessons from the Pros

During the past few years, many traders have suddenly found themselves holding positions in companies that might as well be on life support: no pulse, zero vital signs and little hope of recovery.

Once a stock qualifies as a “worthless security” in the rather hazy definition of the Internal Revenue Service, at least you can claim a consolation prize of sorts in the form of a deduction for your capital loss.

That’s right: you may deduct the entire cost of the stock as a capital loss on Schedule D (Capital Gains and Losses) of your Form 1040 in the year in which the holding gave up the ghost. The loss offsets capital gains, and any excess can be used to reduce ordinary income (wages, dividends, interest, pensions, etc.) up to the $3,000 cap. Additional loss may be carried over to future tax years as well.

But rest assured, the IRS is going to want proof that the dearly departed company was actually DOA and not just catching a quick nap.

The IRS recognizes that it can sometimes be difficult to determine the exact moment that a stock crossed the line from loser to worthless. Therefore, in these cases, it has extended its normal statute of limitations for amending returns from three years to seven years from the due date of the original tax return.

Naturally, tax court rulings have shed some much-needed light on exactly what constitutes worthlessness. For instance, you’re on pretty safe ground if the company has more liabilities than assets and insufficient capital to continue operations, or already has gone out of business and/or liquidated.

In it’s ruling in the recent tax court case of Peter Geddis v. Commissioner, the court reaffirmed that it is incumbent upon the taxpayer to defend their worthless stock deduction. The court found that Geddis failed in several ways to show that the company for which he claimed a $192,000 long-term capital loss was worthless. In fact, Geddis failed to offer proof that he was a shareholder or that the company had hit the skids.

In cases of a line call, be prepared to document your worthless securities claim with financial statements and analysis to prove that said stocks were useless for anything except building a bonfire.

Not Worthless? Sell It!

Claiming a sizable worthless deduction has the potential to flag the IRS, which could sap your time and possibly your money. A far simpler solution to disposing of worthless stock is to sell it, even for pennies. That way, you have a confirmed sale to establish value and a closed transaction showing a loss the IRS will accept without question, no messy financial defense or analysis necessary.

Who wants worthless stock? Some brokerage houses actually buy it back. If yours doesn’t, you can still establish your capital loss by selling to a friend or qualifying relative, including in-laws or distant relatives; anyone other than your spouse, siblings, ancestors or linear descendants will work.

Simply obtain the actual stock certificates from your broker, document the transaction with a check and bill of sale, sign over the certificates to the purchaser and contact a stock transfer agent to have the shares reissued in the purchaser’s name.