By Jim Forrester, Tax Director of Traders Accounting*
Posted: October 26, 2007

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" by the terms set out 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, and so forth) -- 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 Art of the Deduction

In the best of all worlds, when a company formally liquidates, you receive a Form 1099-DIV at year's end, showing the liquidating distribution to all shareholders. Using the original cost basis in the shares, you can, then, easily calculate your loss. You report this amount as sales proceeds on your Schedule D. The distribution date would be the date of sale.

More likely, however, a plummeting share price will be the lone indication that your investment has tanked. Once you determine that your stock is, indeed, worthless, you may claim it as disposed of on the last day of the taxable year in which it became a lost cause.

You will claim it as either a short- or long-term loss, depending on whether you held the security for more than a year; it could be a long-term loss because your sale date is automatically the last day of the current tax year, and you may have purchased it early in the previous year.

What Makes a Stock Worthless?

When does a stock become utterly worthless? The IRS holds that anything short of a flat-line still retains some value. Just because the share price of your once-promising equity is down to pennies won't cut it; nor will the fact that the company is in bankruptcy, is no longer listed on any exchange or has even closed its doors. In short, it has to be a totally lost cause, pure and simple.

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 3 to 7 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 has already gone out of business and / or liquidated.

In its ruling in the recent tax court case of Peter Geddis v. Commissioner, the court reaffirmed that it is incumbent upon the taxpayer to defend his or her 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 of being flagged by the IRS, which could sap your time and possibly your money. A far simpler solution for 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.

*Reprinted (and modified) with permission from Online Trading Academy www.onlinetradingacademy.com Jim Forrester is Tax Director of Traders Accounting (http://www.tradersaccounting.com/)