An investment in the shares of any company means risk -- above all, the risk of the company simply going out of business. If deep financial difficulties arise, a company has the option to file for bankruptcy protection under federal law. This is usually done when a company is insolvent, meaning it is unable to pay creditors. The tax consequences for investors depend on whether company shares are still marketable, or worthless. When a company becomes insolvent, it doesn't necessarily mean you can write off your investment.
Insolvency, Bankruptcy, and Taxes
The IRS does not allow investors to write off investments unless the shares have absolutely no value in the marketplace. Insolvency doesn't necessarily mean worthless shares. Many publicly traded companies unable to pay creditors, or already in bankruptcy, keep trading on the exchanges. In addition, a business bankruptcy does not necessarily result in cancelled, worthless stock, although it often does. In fact, shareholders may see their investments rebound in value after the bankruptcy courts have reorganized the company.
Claiming Capital Losses
If there's truly no market for a publicly traded company's shares, you can take the total write-off on IRS Form 8949. To claim the loss, you must have a cost basis. This is the original amount that you paid for the shares, in addition to any transaction costs. You also report the sale of the shares and proceeds of zero as of the last day of the tax year. You net out capital losses and gains on Schedule D, and take a deduction if a loss is the result. The IRS limits capital losses to $3,000 for individual taxpayers in a single year. If you've exceeded that amount, you may carry the loss forward to the next tax year.
Documenting the Loss
In some cases, an IRS examiner may have questions about the write-off and ask for documentation. For a publicly traded company, this could be a brokerage statement showing a sale of the stock with net proceeds of zero. Many brokerages will perform this service for a minimal fee. You can deduct any brokerage fee or other transaction cost on the trade as well. If you have no documentation of the original trade, but hold the physical stock certificates, you can establish the basis by researching the share price on the date the certificates were issued by the company.
For a privately held company, you must show that the company is dissolved or no longer operating. One form of evidence backing up this claim would be a certificate of dissolution issued by the state where the company is registered. If the business qualified as a "small business" under IRS rules, then "Section 1244 losses" can be claimed as ordinary losses. These are not subject to the IRS's $3,000 annual limit for capital losses. To claim a Section 1244 loss, you must file Form 4797 with the IRS and give the cost basis and date of your original investment.
Founder/president of the innovative reference publisher The Archive LLC, Tom Streissguth has been a self-employed business owner, independent bookseller and freelance author in the school/library market. Holding a bachelor's degree from Yale, Streissguth has published more than 100 works of history, biography, current affairs and geography for young readers.