The IRS Provides Advice For Investors With Losses

Overall, this year has been a mixed bag for shareholders. Descending market averages have plagued investors for the greater part of 2002. However, for the past eight weeks, the leading stock market averages have posted gains. Whether this eight-week trend is a sign of a long-term upswing or merely a temporary rise in an otherwise downward trend, is the subject of much current debate.

Operating in this sea of uncertainty, your clients may be considering (or may have already done) some portfolio pruning before Dec. 31–that is, selling stocks to eliminate those that appear to have poor future prospects or simply to rebalance portfolios.

IRS guidance released earlier this year provides tips for investors with losses, including how to properly claim capital losses and how to deal with worthless stock.

Capital Losses. In general, realized capital losses are first offset against realized capital gains. Then, any excess losses can be deducted against ordinary income up to $3,000 ($1,500 if married filing separately) on line 13 of Form 1040. (There was legislation introduced in 2002 to raise this limit to $8,250, but it got held up in partisan conflict.) Losses in excess of that limit can be carried forward to later years to reduce capital gains or ordinary income until the balance of these losses is used up.

Capital gains and losses on the sale or trade of investments are classified as either short-term (if the property has been held for one year or less), or long-term (if held for more than one year); such losses should be claimed on Schedule D of Form 1040. Although these two categories are subject to different rates in the event of a net gain, a net capital loss resulting from either category is directly deductible from ordinary income up to the annual limit.

The IRS points out that this often works out to the taxpayers advantage, yielding greater relief for losses than if an applicable long-term capital gains tax rate were used. Generally, capital gains rates are lower than the rates on ordinary income. For example, if a taxpayer in the 27% bracket had a net long-term capital gain on stocks of $2,000, the tax due from the gain would be calculated at the 20% capital gains rates for a total of $400. On the other hand, if the same taxpayer has a net long-term capital loss of $2,000, the corresponding tax savings would be calculated at the individuals ordinary rate of 27%, for a $540 reduction in taxes. [News Release IR-2002-127 (11-25-02)]

Worthless Stock. This year the IRS provided investors with a detailed how-to manual for claiming deductions for worthless stock.

General. Worthless stock losses must be: (1) evidenced by closed and completed transactions; (2) fixed by identifiable events; (3) bona fide losses; and (4) actually sustained during the taxable period.

In order for an actual loss to be sustained on worthless stock during the year, the taxpayer must suffer an economic loss. Furthermore, no loss is allowed to be deducted by the taxpayer if there exists at the time of the loss a claim for reimbursement with respect to which there is a reasonable prospect of recovery.

In addition, no loss is allowed unless the stock is wholly worthless. Consequently, a mere shrinkage in the value of stock, even though extensive, does not give rise to a deduction, if the stock has any recognizable value on the date claimed as the date of loss. In other words, the stock must be utterly valueless.

Factual inquiry required. Whether stock is worthless, and whether worthlessness occurs in a particular year, are both based on factual determinations.

Two-part test for the worthlessness of stock. Under the two-part test, for the finding of worthlessness of stock, (1) the stock must cease to have liquidating value (i.e., the corporation has an excess of liabilities over assets) and (2) the stock must lack potential value. The stock must be worthless under both factors before the loss is fixed.

The IRS goes into great detail in the field service advice analyzing both prongs of the test, and in the process, demonstrates just how hard it is to satisfy the test. For example, liquidation of a company is, in and of itself, not necessarily a guarantee that the companys stock is worthless. Likewise, receiving nothing in exchange for stock does not, by itself, signify that a stock is worthless. Instead, a strong combination of factors is required to prove that a stock is really and truly worthless.

In general, taxpayers are urged to claim the deduction for a loss on worthless stock in the first year it appears that all of the factors have been satisfied. This is because the IRS may disallow a loss on a sale if it can be shown that the security became worthless in a prior year. However, taxpayers should keep in mind that the hurdles to be faced in proving that the stock is worthless may be just as difficult (and painful) as the loss on the investment itself. [Field Service Advice 200226004 (3-7-2002)]

Sonya E. King, J.D., LL.M., is an assistant editor for Tax Facts, a National Underwriter Company publication.


Reproduced from National Underwriter Life & Health/Financial Services Edition, December 30, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.