A sign of the times is that many people are holding a variety of investments that have become worthless, or may become worthless in the not too distant future. A recent decision by the United States Court of Appeals for the Seventh Circuit reminds us that timing is critical when claiming a deduction for an investment that has become worthless. The taxpayers in Bilthouse v. United States (January, 2009) owned stock in an S Corporation called S & E Contractors, Inc. The company performed public works construction projects and suffered heavy losses in 1994 and 1995. It filed a lawsuit in 1995 against the City of Jacksonville, Florida to recover certain losses it had incurred in connection with a project it had worked on for the City. The litigation was settled in 1997 without S & E receiving any payment. The taxpayers concluded that their shares of S & E were worthless at that time and claimed a deduction for worthlessness on their 1997 federal income tax return.

The IRS disallowed the deduction on the basis that the shares had become worthless in 1995. IRC Section 165(g) allows a deduction for the year in which a security becomes worthless. In general, cases have said that stock is worthless where the company has no current liquidating value and no potential value. A company has no current liquidating value if its liabilities exceed the current fair market value of its assets. This is probably true of many companies, but the stock is not considered worthless if it is reasonable to expect that the value of the assets will exceed the liabilities in the future. The court concluded that the mere fact that a lawsuit was pending in 1995 did not provide reasonable expectation that the company would have value in the future. The taxpayers presented no evidence to suggest the lawsuit would be successful.

The case illustrates the difficult situation a taxpayer is in with respect to a worthlessness loss. It can certainly claim the deduction too early, but as this case shows, it can also wait too long. The loss must be claimed in precisely the right year. When possible, it is better to find an arm’s length party that will purchase the investment from you, even if its value is nominal. Then you have a closed and completed transaction that establishes your loss. If you cannot do that, you need to claim the loss in the earliest possible year and then consider filing protective refund claims to protect subsequent years until you find out whether the IRS accepts your claimed deduction in the earlier year.