Documenting Tax Losses for Worthless Securities

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Documenting Tax Losses For Worthless Securities
Documenting Tax Losses For Worthless Securities

tax loss for a worthless security, taxpayers must document the loss and establish several key elements. These elements include proving the existence of the security, the amount invested in the security, and the occurrence of a fixed and identifiable event that caused the security to become worthless.

The recent Giunta v. Commissioner, T.C. Memo. 2018-180 case highlights the importance of properly documenting these elements to secure the benefit of tax losses for worthless securities. In this case, the taxpayer failed to provide sufficient evidence to establish any of the required elements, and as a result, the IRS disallowed the claimed loss.

Facts & Procedural History

The taxpayer is an individual who owned several McDonald’s franchises.   Each McDonald’s store was held in a separate entity taxed as an S corporation.  These entities were managed by a separate entity, which was also taxed as an S corporation.

The taxpayer’s entities borrowed $2.5 million from a bank.  According to the taxpayer, these funds were used to invest in an arrangement that was pitched to the taxpayer by his neighbor.  The arrangement called for the $2.5 million to be paid to a local law firm.  The court summarized the transaction as follows:

[The taxpayer’s neighbor] and an associate would fly to London and secure a $132 million loan, using the investors’ $3.5 million startup money to establish their creditworthiness. They would then use that loan to secure a “bank guarantee” with a “face value of $165,000,000 and a maturity date of 10 years after issuance.” Nine days after securing the initial loan, the “bank guarantee” would somehow be used to repay the startup money with a hefty return to the investors who had supplied those funds. An attached “joint venture agreement” was accompanied by a nondisclosure agreement resembling the sort often used by tax shelter promoters. The investment as described in the Term Sheet Concepts set forth no coherent business or investment strategy….

By investing $2.5 million, petitioner would supposedly get a 50% interest in a New York limited liability …. The investment agreement says that petitioner was to send $2.5 million to an escrow account at a law firm….

[One of the McDonald’s entities] received a wire transfer of $1.9 million from the [law firm] escrow account. There is nothing on the wire transfer cover sheet to indicate what this payment covered or why it was being made. The wire transfer cover sheet contains no “re” line and makes no reference to any sort of investment. Petitioner testified that this $1.9 million transfer represented a payout on his $2.5 million “overseas investment.”

The taxpayer reported the losses on his income tax return as an offset to the capital gain income he received from selling his McDonald’s entities that year.

The IRS audited and disallowed the loss.

The Worthless Security Tax Loss Rules

Section 165(g) sets out the general rule for worthless securities:

If any security which is a capital asset becomes worthless during the taxable year, the loss resulting therefrom shall, for purposes of this subtitle, be treated as a loss from the sale or exchange, on the last day of the taxable year, of a capital asset.

It defines the term “security” to include:

(A) a share of stock in a corporation;
(B) a right to subscribe for, or to receive, a share of stock in a corporation; or
(C) a bond, debenture, note, or certificate, or other evidence of indebtedness, issued by a corporation or by a government or political subdivision thereof, with interest coupons or in registered form.

Thus, to take a tax loss for a worthless security, the taxpayer has to show that there was a security, the amount the taxpayer invested in the security, and that the security became worthless in the tax year.

Establishing the Worthless Security Tax Loss

The court concludes that the taxpayer did not establish any of the elements required for a worthless security tax loss.

Was there a security?

In this case, the security that was purportedly worthless was a joint venture.  Does a joint venture qualify as a “security?” A literal reading of the Code would seem to limit the loss to losses from corporations.  This Giunta case suggests that a strict reading of the Code is appropriate.  But the courts and the IRS have allowed worthless security losses for investments in partnerships in prior cases.  See Rev. Rul. 93-80, 1993-2 C.B. 239, for example.  This guidance has allowed the losses without addressing whether the partnership is a security for purposes of Sec. 165(g).  The court in Giunta did not have to get to the issue as it did not find that the taxpayer even made any investment or held a security given the absence of evidence establishing the investment.

Proof of tax basis in the investment?

For proof of the investment and the tax basis in the investment, the taxpayer pointed to accounting entries in its Quickbooks records.  These entries just showed that the taxpayer’s business entities borrowed the funds.  The taxpayer also pointed to the return of $1.9 million from the law firm as circumstantial evidence to show that the investment was in fact made.

The court did not find this evidence to be acceptable.  It noted that there was no evidence that the $2.5 million was ever paid to the law firm.  This missing evidence might have included bank records showing the funds being transferred or, as the court suggested, testimony from someone at the law firm.

What is the identifiable event of worthlessness?

That the securities had become worthless during the tax year was also at issue in this case.  To be worthless the taxpayer must generally point to a “fixed and identifiable event” that caused the security to lose all value.  The Echols v. Commissioner, 935 F.2d 703 (5th Cir. 1991) case is often cited for this rule.  In Echols, the partnership held a meeting where the partners offered to give their partnership interests away for free.  The meeting was the event that showed that the partnership interests were worthless.

In the present case, the taxpayer presented annual emails with the neighbor that suggested that there would be no payout at the time.  Unlike Echols, the emails in the present case did not go further and suggest that the interests were worthless.  Thus, the court also did not find the emails to be sufficient to show that the security became worthless.

The Takeaway

This case highlights the importance of documenting losses for worthless securities and establishing the necessary elements to secure tax losses. To claim a tax loss for a worthless security, a taxpayer must demonstrate the existence of a security, the amount invested in the security, and the identifiable event of worthlessness. The court found that the taxpayer did not establish any of these elements in the case, and therefore, the loss was disallowed. It is crucial for taxpayers to maintain detailed records and seek expert advice to ensure accurate classification of investments and transactions, as well as to remain aware of the potential tax implications.

Absent a worthless securities loss, the taxpayer may also be able to take a bad debt deduction. This is a separate type of tax deduction that can be available if a worthless securities loss is not available. There are also court cases that explain when this type of deduction is allowable.

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