When you own stock in what is now a bankrupt company, one thing is for sure: It was a lousy investment. Unfortunately, that doesn't automatically mean you can write off the cost of your shares for tax purposes.

No Theft Loss
for Insider Trading Victims

    If you claimed a tax loss for a decline in stock value resulting from accounting fraud or misconduct by corporate insiders, there could be more bad news: The IRS says you cannot claim a theft loss for stock that you purchased on the open market. Adding insult to injury, some taxpayers may be slapped with accuracy-related penalties for deducting such losses. (IRS Notice 2004-27)
   
Background: The tax law allows you to deduct losses from thefts and casualties, such as natural disasters, to the extent the losses are not compensated by insurance or other means. These losses are deductible on your personal return, subject to limits. However, it is well-established that you cannot deduct a loss occurring because of a decline in the stock market.
    Due to a rash of highly publicized "insider trading" violations and other acts of misconduct in recent years, some taxpayers who own stock in these companies sought some solace by deducting a resulting decline in stock value on their personal tax returns. The IRS notes that the courts have consistently denied theft losses relating from corporate misconduct when the stock was purchased on the open market and not from officers who may have made representations. 
    For example, in one case, the Tax Court ruled that the fact that Worldcom officials were criminally convicted of fraud does not allow shareholders to claim a theft loss. (Taghadoss, TC Summary Opinion 2008-44)
    Silver tax lining: You may still be able to deduct a worthless stock or a capital loss attributable to a decline when you sell the stock, as described in this article.


Here are the basic rules.
 
You can claim a capital loss deduction when you sell shares for less than you paid for them. However, your write-off is limited to the amount of your capital gains for the year (if any) plus $3,000 ($1,500 if you use married filing separate status). Any excess loss carries over to the next year, subject to the same $3,000 (or $1,500) limitation.    
 
Under the tax law, you can also claim a capital loss deduction when your shares become wholly worthless. The same dollar limitations apply in this case. However, you get no deduction for "partial worthlessness."

Bottom line: To claim a tax write-off, you must either:

  • Sell the shares for whatever they can fetch and claim the resulting capital loss now.
     
  • Wait until the shares become completely worthless and claim your capital loss at that time.
Beware: Relying on the worthless stock deduction rule can be a tricky business. Shares of "delisted" bankrupt companies often continue to trade for a few cents (or even fractions of a cent) via the so-called Pink Sheets system. As long as the shares are still being traded, the IRS can say you are not entitled to a worthless stock deduction.
 
The tax-smart strategy is generally to simply sell your shares while they are still listed on the NYSE, NASDAQ, or American Stock Exchange, claim your rightful tax loss, and move on. Don't wait until your shares are "delisted." At that point, it may be difficult to get any tax benefit from them.
 
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