You thought those 5,000 shares of Stained Glass Windshield Co. (ticker: STAIN) were a bargain at $0.25 per share. But now, six months later, the stock seems to have disappeared from all listings. When you asked someone about it, she said the shares were worthless. Are we looking at a capital loss here? It's very likely. Let's just clear up a few things.

If the company was literally liquidated, you'll be notified of that fact (hopefully) and will likely receive a 1099-DIV form at the end of the year that shows a liquidating distribution to you, the shareholder. Treat this liquidating distribution as if you sold the stock for the amount of the distribution. The date of "sale" is the date that the distribution actually took place. With this information, using your original cost basis in the shares, you can compute your gain or loss. But this is the exception and certainly not the rule.

If the company has not actually been liquidated, but is just deemed worthless, the rules are a little bit different. You can deduct a loss for worthless stock or other securities (e.g., a bond, debenture, note, certificate, or other evidence of indebtedness). If you determine that the shares are worthless, you are deemed to have disposed of the shares on the last day of the taxable year in which they become worthless. So your loss could be either a short-term or long-term loss, depending on what date you purchased the shares.

Example #1: You originally purchased your 5,000 shares of STAIN on Dec. 12, 2001. You determine that STAIN is worthless in July of 2002. You are deemed to have disposed of your STAIN shares on Dec. 31, 2002. In this case, your loss would be a long-term capital loss. Why? Because you held the shares for more than one year (from Dec. 12, 2001 to Dec. 31, 2002). On your 2002 tax return, you would report the "sale" date as 12-31-02, indicating a "sale" price of zero.

Worthless? Sez who?
You must keep in mind that a security must be totally worthless for the loss deduction to be claimed. No loss deduction is allowed for partial worthlessness, or for a mere decline in the value of the security. To stay on the right side of the law, you must make sure that the stock is worthless in the eyes of the IRS. Many stocks that have taken major hits in the market may still be alive, even though they are trading for mere pennies per share.

Your broker should be able to tell you if the security is still trading. Some brokers even have divisions that will buy back your remaining shares (for pennies), allowing you to close out your position. But make sure the broker buys the shares from you. Simply giving the shares to your broker to clean up your account will not automatically give you a worthless stock deduction.

Example #2: You finally track down the fact that your STAIN shares are still alive and kickin'. Kinda. You find that they are not traded on any exchange, but the company is still operating. In fact, it is operating under bankruptcy protection. The company says that it hopes to get back on its feet some day, but nobody knows if that is a realistic expectation or simply a pipe dream. At this point, it's very likely that your stock is still not "worthless," as that word is defined in the tax code. The company is still somewhat viable according to published reports and financial analysis. The simple fact that you can't sell your shares in any market won't make your shares "worthless" for tax-reporting purposes. Bankruptcy, per se, does not make the stock "worthless." So, no worthless stock deduction for this baby right now.

The IRS definition of "worthless" is really quite loose and subject to interpretation, which is why a number of these cases have gone to court. Reviewing all the relevant cases, you basically come down to the following key points for the definition of "worthless":

  • What is the current liquidating value of the stock and what value might it achieve in the future through the foreseeable operations of the corporation? If both of these values are wiped out, a loss can almost certainly be claimed.
  • If the liabilities of the corporation exceed its assets, and there is no reasonable hope or expectation that continuation of the business will yield a profit (given the nature of its assets and business), then the stock is worthless.
  • If you can show balance sheet insolvency and identifiable events, such as a cessation of business or a sale of substantially all of the company's assets, the stock is very likely worthless.

So the determination of "worthless" will require some financial statement analysis and could still be subject to interpretation (and disagreement by the IRS). It's not as easy as you might think on first blush.

Why go through the hassle? Here's a tip you can use to plan for the actual sale of the shares and generate a loss in a form and timeframe that is beneficial to you from a tax standpoint:

Sell the stock to your mother-in-law
Consider selling the junk for pennies to a friend or distant relative. (In-laws qualify, as does anyone other than your spouse, siblings -- either whole or half-blood -- ancestors, or lineal descendants.)

You then have a closed transaction, and the loss is certain and deductible in the year of sale. If the stock ever comes back and is worth something, at least the money stays with friends or family. Here's how you might do it:

  • Get the actual stock certificates from your broker.

  • Formally sell the shares to the purchaser, with a check for payment and a bill of sale.

  • Sign over the stock certificate (on its back) to the purchaser. Have the signatures verified by your banker and/or a local stockbroker.

  • Send the certificate to the stock transfer agent. Explain that the shares have been sold, and ask them to cancel the old shares and issue a new certificate to the new owner.

Bingo! For a pittance, your friend or relative has just bought a placemat or birdcage liner... but you have a capital loss. You have a stock sale, a closed transaction, and an indisputable loss. No financial statement review and analysis. No subjective decisions regarding any potential future turnaround by the company. No second-guessing from the IRS. Sweet.

For more information on worthless securities, check out IRS Publication 550 (Acrobat Reader required). But remember that even Publication 550 doesn't address the complex issue of exactly when a stock becomes worthless in the eyes of the IRS. So if you are holding some questionable stock, consider selling the junk and being done with it.

Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.