Deducting losses on worthless investment securities.

• Author: Thornton, David A.

Over the past several years, the financial crisis has resulted in significant impairment for investors in debt and equity securities. For corporate and other business investors, these impairment losses are often highlighted on the financial statements as "other than temporary impairment," which is deemed to be a permanent reduction in the value of these securities and establishes a new cost basis for GAAP.

While these impairment losses can be deducted for tax purposes under some circumstances, taxpayers will often find that the tax statutes governing deductible losses on worthless securities are much more restrictive than the GAAP standards for recording these losses and, consequently, the GAAP impairment losses are often not currently deductible. This is evidenced by the increasing frequency of recorded deferred tax assets related to impaired securities in the financial statements of business investors.

Understanding the rules for deducting losses on worthless securities is necessary to determine the correct timing of the loss deduction. Special rules apply to certain taxpayers, and advance planning may avail some taxpayers of loss deductions sooner than they would otherwise be allowed. These rules are summarized below.

Sec. 165

The general rule for deducting losses on worthless investment securities is found in Sec. 165(g), which permits a loss deduction for a security that becomes worthless during the tax year, but only if the security is a capital asset in the taxpayer's hands. The loss amount is determined by treating it as having resulted from a hypothetical sale or exchange of the security on the last day of the tax year in which the security becomes worthless. This deduction can be considered where the taxpayer is unable or unwilling to sell or otherwise dispose of the security in a taxable transaction. Otherwise, the loss could obviously be deducted upon such a disposition of the security under Sec. 1001.

Sec. 165(g)(2) defines a security as any of the following: a share of stock in a corporation; a right to subscribe for, or receive, a share of stock in a corporation; or 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. With respect to debt securities, standard investment-grade securities that are offered for sale on the public markets will likely be issued in registered form and will therefore qualify as securities for purposes of deducting worthless securities losses. Sec. 165(j) denies a deduction for losses on securities that are required to be issued in registered form but are not registered. However, numerous exceptions and special rules apply to the registration requirements, as set forth in Sec. 163(f). An unregistered debt instrument may constitute a loan, in which case the deduction for worthlessness may be governed by Sec. 166 as a bad debt.

To determine whether a loss is governed by Sec. 165(g), the taxpayer must determine whether the security is a capital asset. This determination is routine for most taxpayers, as nearly all investment securities are capital assets for both business and individual taxpayers. However, under some circumstances the investment securities held by certain taxpayers are not capital assets. For example, investment securities held by a securities broker as inventory are expressly designated as ordinary (i.e., not capital) assets (Sec. 1221(a) (1)). Likewise, debt securities owned by a bank are expressly accorded ordinary gain or loss treatment (Sec. 582(c)). Sec. 165(g)(3) generally holds that stock in an affiliated corporation is not treated as a capital asset for purposes of applying Sec. 165(g).

While Sec. 165(g) addresses worthless loss deductions only on securities that are capital assets, Regs. Sec. 1.165-5(b) clarifies that worthless securities losses that would be ordinary losses in the hands of the taxpayer are deductible under Sec...