February 15, 2024
By Sam Sino, CPA, Tax Manager, Alternative Investment Group
Unfortunately, not all investments perform well over time. Amid the potential for profit lies the risk of encountering worthless securities—investments that have plummeted in value to the point of nonexistence. When this happens, it’s crucial to understand the tax implications in order to manage potential losses effectively. This article will explore what constitutes a worthless security and the tax issues surrounding such securities held by investment funds, such as timing. The Internal Revenue Service (IRS) requires that the loss from a worthless security be claimed in the tax year that the security became worthless. This can be a complex determination since it is not always obvious when a security loses all value.
When is a security worthless?
Before identifying a worthless security, we must understand what a ’security’ means from a tax perspective. As per the IRS, the term ’security’ encompasses a broad range of financial instruments. This includes but is not limited to, stocks, partnership or trust beneficial ownership interests, debt instruments, and specific notional principal contracts. Additionally, a security can be evidence of an interest in, or a derivative financial instrument related to these assets, along with certain hedging instruments tied to them.
According to the IRS, a security is deemed worthless when it retains no present or prospective value, and it is unreasonable to anticipate any resurgence in its valuation. This situation often arises when an entity ceases operation permanently or enters a state of non-recoverable bankruptcy. However, just because a stock’s value has decreased significantly, it does not automatically qualify it as worthless. The investor must confirm that the stock has no market value and that the company is not operating or is in liquidation. The investment fund should maintain records that support the worthlessness claim, including any documentation from the issuer, relevant news articles, financial statements, notices to investors, and any other correspondence. The year of worthlessness is important to prove as it could be challenged.
When comparing the treatment of a worthless security for tax purposes versus Generally Accepted Accounting Principles (GAAP), there are key differences to consider. GAAP for investment funds requires that securities and investments be recorded and valued at their estimated fair value on the measurement date. For listed securities traded on an active market, that would be the quoted price for the security on the measurement date. Securities and assets for which market quotations are not readily available would still need to be valued at fair value, which would be what market participants would be willing to transact at on the measurement date. An unrealized loss would be recorded on the income statement for a security that lost value. For a security deemed worthless, its fair value would be written down to zero but still reflected as an unrealized loss until the security is disposed of. Unlike tax accounting, where the loss is recognized only once it is deemed completely worthless, GAAP requires a more proactive approach in continuously evaluating the fair value of securities and recording gains and losses on each measurement date. GAAP is primarily concerned with providing a true and fair view of a company’s financial health for its stakeholders. In contrast, tax accounting is focused on adherence to tax laws and regulations.
When one determines for tax purposes that a security has become totally worthless, an investment fund can take a capital loss under IRC Section 165. The resulting loss may be deducted as though it were a loss from a sale or exchange on the last day of the taxable year in which it has become worthless. The asset the investment fund is considering to be worthless needs to be a capital asset. Capital assets are properties held by an individual or a business for investment purposes or productive use in their trade or business rather than for sale to customers. The distinction between capital assets and other types of assets is essential for tax purposes because the sale or exchange of a capital asset may result in a capital gain or capital loss, whereas the sale of other types of assets can result in ordinary income or loss.
Potential Workarounds
As the determination to worthlessness for tax purposes is facts and circ*mstances-driven, it can be challenging to decide when to take the loss. There are several strategies that taxpayers might consider in navigating this situation:
Abandonment – To abandon a security, an investment fund must permanently surrender and relinquish all rights in the security and receive no consideration in exchange for it. Taxpayers must substantiate the abandonment with evidence showing that they’ve given up all rights in the asset and that no sale or exchange took place.
Sale for a nominal amount to an unrelated third party – Selling the securities to an unrelated third party for a nominal sum, such as $1 or $10, effectively equates to recognizing a loss on worthless securities while still executing an actual sale transaction.
Professional Valuation – If there is uncertainty about the current value of a security, obtaining a professional valuation may help establish the lack of worth for tax purposes, especially if the market is illiquid or the future of the issuing entity is in question.
Losses on Affiliated Corporations
There’s a special consideration when the worthless security is from an affiliated corporation. If a domestic taxpayer owns 80% of the voting and 80% of the total value of each class of non-voting stock of a corporation, and the securities become wholly worthless, the loss may be deductible as an ordinary loss. This classification can significantly impact the tax treatment of the loss.
Conclusion
The tax implications of worthless securities owned by investment partnerships can offer some solace to investors facing losses in their portfolio. By understanding the IRS’s rules for deduction and keeping proper documentation, investment funds and their investors can navigate these situations with greater confidence. However, the intricacies of these tax laws underscore the importance of consulting with your Marcum LLP tax professionals to ensure accurate tax treatment and compliance with federal regulations.
