Tax counsel often advise taxpayers to apply Internal Revenue Code (Code) section 165(a) to claim an income tax deduction for an uncompensated loss sustained during the tax year. An uncompensated loss occurs when the taxpayer receives insurance proceeds, a reimbursement, or any other compensation related to the loss. The tax character of the uncompensated loss can be an ordinary income deduction or a capital loss, depending on the facts and circumstances of the loss event.
Treasury Regulation 1.165-1(b) provides that in order for the loss to be allowable as a tax deduction, the loss must be: (i) evidenced by a closed and completed transaction; (ii) fixed by identifiable events; and (iii) actually sustained during that tax year. In order to satisfy the Regulation 1.165-1(b) requirements for claiming a loss deduction, typically the taxpayer must walk away from or otherwise abandon the property that suffered the loss.
Another taxpayer application of Code section 165(a) is what is typically called the “worthless stock” deduction. This term is often used because the taxpayer is claiming a tax deduction related to the worthlessness of the stock of a private company or a similar ownership interest. For example, a parent corporation may claim a loss deduction related to the worthlessness of the common stock of a subsidiary corporation.
As this discussion will illustrate, the section 165(a) worthless stock deduction is not limited to the stock of a corporation. The section 165(a) deduction is also available with regard to the worthlessness of a partnership interest, a limited liability company (LLC) membership interest, or a similar equity interest. Regardless of the type of security ownership interest, the section 165(a) deduction becomes available when the ownership interest becomes worthless.
This discussion describes the criteria that tax counsel and the Internal Revenue Service (IRS) consider to determine the worthlessness of a security. In particular, this discussion explains that the abandonment of the ownership interest is not a requirement for the taxpayer to claim a section 165(a) worthless security tax deduction.
CLICK HERE to read the full article, which was originally published in ALI CLE’s The Practical Tax Lawyer.