Unload that 'worthless' stock
Even shares in companies that have gone bankrupt have a market. Finding it, and cashing out, can mean claiming a loss at tax time.
Now that the stock market has laid its third egg in as many years, just about every investor has had a chance to lose a shirt - or two - on a dotcom or high-tech dud.
So now it's high time to flush these turkeys from your portfolio. But if the investment has become completely worthless, you'll have to go to some extra work to write the loss off on your income taxes.
The Internal Revenue Service has had plenty of experience with taxpayers and worthless securities. It even puts out a pamphlet, Publication 550, which explains the mechanics of such losses.
It's not a terribly complicated procedure, as far as IRS rules go, but it does involve extra homework by the investor to make sure all the appropriate rules are followed.
For starters, the IRS demands that a security be sold before a loss is claimed. That puts the onus on the investor and his or her stockbroker to find a market for the investment. For the most part, any shares sold now won't help you cut your bill for tax year 2002.
Some fallen angels may get booted from the big exchanges when they declare bankruptcy, but their stock still trades in what are called "pink sheets." Even if a company is trading for a cent a share, or a tenth or hundredth of a cent, there sometimes can be trading, and if a willing buyer is found, then the security has to be sold to establish its cost basis.
"Many people are under the impression that if a company is bankrupt [its stock is] worthless," says Max Klinger, a tax-policy expert based in Laramie, Wyo. But even disgraced energy giant Enron Corp. still trades while in bankruptcy court, and although a share fetches just a few pennies, it has a market nonetheless.
Selling the stock of a firm that has gone bankrupt is "cleaner and neater in terms of IRS [treatment]," says Mary Burnes, who manages equity trading for St. Louis-based brokerage house Edward D. Jones. But sometimes bad things happen to bad companies, or, as Ms. Burnes puts it, "There are some stocks that just delist and never trade."
So what do you do if there are no buyers? Here again, a good stockbroker can still ride to the rescue. In what are sometimes called "penny for the lot" transactions, or variations on that theme, a brokerage will buy its client's worthless stock for a lowly penny, for instance. This creates the transaction and the paperwork that the IRS needs to see before there is a write-off attempt.
Hilliard Lyons Inc. a regional broker based in Louisville, Ky., will pay the princely sum of $1 for a client's worthless securities, no matter how many shares are involved. Then it issues what it calls a "nonmarketable securities letter" to let the IRS know of the transaction.
Edward Jones doesn't offer a penny-for-the-lot trade, but it does follow a tactic that many other brokers use - creating a letter that declares the stock a dead duck. Jones calls such a document a "no-market letter," which lets the IRS know that a market for a security no longer exists and it can't even be traded.
If one of these letters is issued, the IRS has decreed that the "sale" for tax purposes has taken place on the last day of the year. The government also says a claim for worthless stock must be taken in the year the investment actually loses all of its value.
Settling on a date could be tricky for a stock that has simply fallen off the radar screen over time. But Donna LeValley, a tax expert with J.K. Lasser, said the IRS has taken this into account. It permits taxpayers to file an amended return with a refund claim within seven years from the due date of the return of the proper year, or even later under some circumstances.
If challenged by the IRS, Max Klinger says it's the taxpayer's duty to prove the investment is completely worthless.
"That's a frequent point of contention between the IRS and taxpayers," he says.
Worthless investments show up on income-tax returns on the same pages as most other securities transactions - on Schedule D of the income-tax form. But taxpayers will need to do a little explaining of their situation, and convince the IRS that the loss they are claiming is genuine.
Should some value return to the stock you just wrote off, the IRS has at the ready what is known as the Arrowsmith Doctrine. Under Arrowsmith, an investment that has become worthless, then regained value, now gets plopped onto your tax return. So if a loss of $2,000 was claimed, and for some reason the company rises from the ashes and grabs a value of $1,000, then taxes are due on this.
It's a rare day when something like this happens, but there have been instances when bankrupt firms have collected lawsuit awards that have breathed new life into them.