Revenue Procedure 2001-43: Claiming a Worthless Stock Loss

When stock-based compensation becomes worthless, tax rules provide a method for individuals to claim a loss. This guidance from the Internal Revenue Service (IRS) addresses the situation where an employee or independent contractor has previously recognized income from receiving company stock, only to see that stock lose all its value. The tax code offers a way to recover, through a capital loss deduction, the amount that was previously included in taxable income.

This relief is not a general provision for all stock market losses. It specifically applies to losses on shares acquired as compensation. The tax law outlines the requirements for eligibility, the method for calculating the loss, and the steps for claiming it on a tax return. Understanding these rules is the first step for any taxpayer who paid taxes on stock that is now worthless.

Eligibility for Relief

The primary candidates for this relief are employees and independent contractors who have received stock or stock options from a company as part of their compensation package. The deduction is designed to address the financial downside when this form of compensation fails to retain its value.

The relief applies to stock acquired through nonstatutory stock options (NSOs) and restricted stock units (RSUs) where the value of the stock was included in the taxpayer’s gross income. This means that at the time of exercise for NSOs, or at the time of vesting for RSUs, the fair market value of the shares was reported as ordinary income. This income would have appeared on the individual’s Form W-2 or Form 1099 and was subject to income and employment taxes.

A condition for claiming the loss is that the stock must have become completely worthless. More commonly, the stock becomes worthless when the issuing company goes bankrupt or is liquidated, leaving shareholders with nothing. The taxpayer must be able to prove that the stock has zero value and cannot be sold or traded. A simple decline in stock price, even to a very low value, is not sufficient.

Finally, the taxpayer must have continuously held the stock from the time they acquired it until the moment it became worthless. If the stock was sold, gifted, or otherwise disposed of for any amount of money, even a fraction of a cent per share, the loss cannot be claimed as a worthless stock deduction.

Calculating the Allowable Loss

The allowable loss is based on the taxpayer’s cost basis in the stock. This basis is the sum of the amount the taxpayer previously included in gross income as compensation plus any amount paid out-of-pocket for the stock, such as the exercise price for stock options.

To illustrate, consider an employee who exercised nonstatutory stock options. They paid an exercise price of $5,000 and recognized $25,000 of ordinary income at the time of exercise. Their total basis in the stock is $30,000. If the company later goes bankrupt and the stock becomes worthless, the employee’s allowable capital loss is $30,000. This represents the amount they were taxed on as income plus the cash they paid.

It is important to distinguish this from a typical investment loss on shares bought on the open market. While the tax treatment is similar, the basis calculation for compensatory shares is unique. This ensures that the taxpayer is made whole from a tax perspective on both the income they were deemed to have received and the money they invested.

Required Documentation and Information

The IRS requires clear evidence of the entire lifecycle of the stock, from the initial recognition of income to the final determination of worthlessness. The required documentation includes:

• A copy of the federal income tax return for the year in which the compensation income was originally reported.
• The corresponding Form W-2 or Form 1099 from that same year, which shows the specific amount of compensation income that was reported to the IRS and included in the taxpayer’s gross income.
• Records that demonstrate the acquisition and holding of the stock. Brokerage statements are ideal for this purpose, as they will show the date the shares were acquired, any price paid, and confirm that they were held in the taxpayer’s account. These statements should cover the entire period from acquisition until the stock became worthless.
• Proof that the stock is worthless is required. This can take several forms, such as a formal notice of bankruptcy from the company, a letter from a court-appointed liquidator, or official documentation of the stock being delisted.

How to Claim the Loss

The process of claiming the worthless stock loss involves reporting it on the tax return for the year in which the stock became worthless. If the taxpayer has already filed for that year, they must use Form 1040-X, Amended U.S. Individual Income Tax Return.

The capital loss itself is reported on Form 8949, Sales and Other Dispositions of Capital Assets. On this form, the taxpayer will list the worthless stock, showing a sale date of the last day of the year in which the stock became worthless and a sales price of zero. The loss from Form 8949 is then carried over to Schedule D, Capital Gains and Losses, and ultimately to Form 1040 or 1040-X.

On Form 1040-X, if an amended return is needed, there is a section for explaining the changes being made to the original return. In this section, the taxpayer should write a statement explaining that they are claiming a worthless stock loss, referencing the attached documentation and briefly summarizing the situation.

The final step is to assemble the complete package for submission to the IRS. This includes the completed Form 1040 or 1040-X, Form 8949, Schedule D, and copies of all the supporting documents. The entire package should be mailed to the IRS service center designated for processing returns, the address for which can be found in the form instructions.