IRS Not Easily Convinced That Stock Is ‘Worthless’

Believing a stock is worthless is one thing. Proving it to the Internal Revenue Service is quite another.

The IRS allows a tax write-off for shares or other investments that lose all of their value. But the IRS’ definition of what constitutes a worthless security is so strict that investors in Enron Corp., Polaroid Corp. and many other bankrupt companies should consider selling their stock now if they want to lock in their losses for 2001 tax purposes, financial experts say.

A stock that’s still trading--even for pennies--isn’t considered worthless by the IRS, said Mark Luscombe, principal tax analyst at CCH Inc., a tax research company in Riverwoods, Ill.

“One indication of worthlessness is if you’re trying desperately to sell it and no one will buy it,” Luscombe said. If any investor is willing to buy the stock, the IRS considers it to have some worth, he said.

Enron’s shares rose 188% last week, to 75 cents, on the New York Stock Exchange, as some investors speculated that the stock might be worth something when the company emerges from bankruptcy reorganization. In most bankruptcies, however, stockholders receive nothing for their shares, said Melanie Rovner Cohen, a Chicago bankruptcy attorney.

If Enron emerges from bankruptcy without compensating its shareholders, those investors should be able to take a worthless-stock write-off, Luscombe said. The issue is timing.

Investors who don’t want to pay brokerage commissions to sell their bankrupt-company shares at penny prices can wait until a bankruptcy is finished and take the worthless-stock deduction if they don’t receive anything for their securities.

But bankruptcies can take months or even years to conclude. Typically, it’s more efficient for investors who want to deduct losses on investments to sell their shares for whatever they can get while the stock still trades, tax experts said. Those losses can be used to offset any realized investment gains, and any leftover loss can be used to offset as much as $3,000 of ordinary income each year.

Investors in Enron and other large companies that go bankrupt have one advantage: The fate of their investments will be well-publicized. Other investors aren’t so lucky. Smaller bankrupt companies often fade away with little fanfare, making it difficult or impossible to sell the shares or to pinpoint when the company went out of business.

That’s important for several reasons. First, a worthless-stock deduction must be taken in the same tax year that the investment loses its value, and the investor must prove the shares had some value either at the beginning of the year or at end of the previous year.

Second, an investor in stock that’s no longer traded must prove that the investment is actually worthless, Luscombe said. If a company remains in business in any form, the stock may still have some worth and the IRS can deny a deduction, he said.

To prevail in an audit, an investor should be able to point to a definite event that establishes the business cessation, such as a filing for liquidation, the sale of all the company’s assets or the appointment of a Bankruptcy Court receiver, he said.

Because the task often can be difficult, investors have up to seven years to amend their old tax returns to take a worthless-stock deduction retroactively.