Example of a stock certificate

I. Introduction and Overview

This article addresses the federal income tax issues arising from corporate stock and debt that become wholly or partially worthless.1 In particular, the article addresses the following questions:

1. What events or circumstances permit or require a corporate creditor or stockholder to recognize a loss relating to stock or debt?

2. What determines whether a holder's loss on a debt or stock investment is ordinary, capital or nondeductible?

3. What special rules apply when the corporate debtor and creditor are related?

Surprisingly, given that stock and debt losses are commonplace, the answers to all of these questions are to some extent either unclear or illogical. In particular, the law on whether losses on stock and debt investments are capital or ordinary is marked by gaps and unresolved conflicts and is based on two inconsistent policies that have never been reconciled outside the consolidated return context. The goal of this article is to summarize the current state of the law on these questions, examine the relevant policy considerations and suggest what seem to be more reasonable approaches.

The two principal sources of problems in determining the timing and character of losses on stock and debt are (1) the "sale or exchange" requirement for capital gain or loss treatment, and its mirror image-the extinguishment doctrine -which have been overridden partially but not completely by various statutes,' and (2) with respect to debt, a strange system that divides debt instruments into one of three classes-capital assets that are securities, capital assets that are not securities and ordinary property. The former means that the character of a loss on a stock or debt investment depends not only on the character of the underlying property, but how the loss is incurred. The latter means that two separate Code sections govern losses on debt-Code sec. 165(g) for debt securities and Code sec. 166 for other debt instruments.

If a stock or debt instrument is a security under Code sec. 165(g)(2) (which encompasses stock, rights to acquire stock and debt instruments in registered form), the holder of the instrument cannot obtain an ordinary deduction for the partial worthlessness of the instrument because Code Sec. 166 has a specific exception for securities and cannot obtain an ordinary deduction for the complete worthlessness of the instrument unless certain ownership and gross receipts requirements set forth in Code sec. 165(g)(3) are satisfied. As such, a sale of the instrument at a loss, a settlement of the instrument with the issuer at a loss or a complete worthlessness of the instrument all give rise to a capital loss. The tax system does not, however, completely foreclose the possibility of ordinary loss treatment. It would appear that the holder may be able to obtain an ordinary loss deduction under Code Sec. 165(a) by irrevocably "abandoning" the stock or debt prior to the occurrence of an event or series of events establishing the instrument's complete worthlessness.4

The character rules for debt that is ordinary property are relatively simple and straightforward: Any loss on such a debt is an ordinary loss. This rule covers lenders governed by Code sec. 582, as well as dealers in securities, at least with respect to debt not treated as held for investment under Code sec. 475(b)(1)(A).5

If the instrument is debt that is a capital asset but not a security described in Code Sec. 165(g)(2), a collection of disjointed rules applies to determine whether the deduction for partial or complete worthlessness is ordinary or capital or, in some cases, nondeductible. These rules are uncertain and irrational in many respects.

Many of the rules governing losses on stock and debt issued by corporations can change dramatically if the owner of the stock or debt is a majority shareholder. For example, if the owner of the stock or debt is a corporation that is a member of the same consolidated return group as the issuer, the consolidated return regulations generally supersede the timing and character rules otherwise applicable.6 Various other rules can apply if the owner and issuer of the security are related but do not file a consolidated return. This article examines the various applicable rules and considers whether it is appropriate to attempt to achieve better matching of timing and character of holder deductions and issuer income or other tax detriments.

Part II of this article discusses the rules governing losses on stock and debt securities. Part III addresses issues arising with respect to debt instruments that are not securities. Part IV focuses on related-party issues. Part V addresses issues relating to the issuer of the stock or debt. Part VI re-examines certain aspects of current law and makes several proposals for change.

II. Timing, Amount and Character of Losses on Securities

Code Sec. 165(a) provides, in broad terms, that "there shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise." More particularly, Code sec. 165(g)(1) provides that a loss arising from the worthlessness of a "security" (the definition of which encompasses stock, rights to acquire stock and certain debt instruments) held as a capital asset is a loss from the sale or exchange of a capital asset occurring on the last day of the tax year if the security becomes worthless during the tax year.7 Thus, to fall within the scope of Code sec. 165(g)(1), the following requirements must be satisfied:

1. The instrument must be a capital asset.

2. The instrument must be a security.

The security must be worthless at the end of the tax year.

3. The security must not have been worthless at the beginning of the tax year.

As discussed immediately below, if the last three requirements are met with respect to a security that is not a capital asset, the taxpayer is entitled to an ordinary loss.

A. Is the Security a Capital Asset?

The first issue to be addressed in analyzing the character of a loss under Code sec. 165(g) with respect to an equity or debt instrument issued by a corporation is whether the instrument constitutes a capital asset in the hands of the holder. If the instrument is not a capital asset, then any loss allowed in connection with the worthlessness or sale or exchange of the instrument will be ordinary.8

After the Supreme Court's 1988 decision in Arkansas Best Corporation? stock or debt securities of a corporation will almost always be considered to be capital assets unless the holder is a securities dealer (and not holding the stock as an investment)10 or is in the lending business." With respect to stock, the quintessential capital asset, the Arkansas Best decision probably did not have much effect, except in the unusual case (such as the Arkansas Best case itself) in which the taxpayer had a colorable argument that the investment in the stock was part of the everyday operation of the stock owner's trade or business.1 With respect to debt, the impact was perhaps greater. Prior to Arkansas Best, it was arguable that a loan made by a taxpayer engaged in business but not in the lending business was an ordinary asset if the loan was made in the ordinary course of the taxpayer's trade or business. This argument probably could not have prevailed in the case of an investment in publicly offered bonds, debentures or notes, but might have been viable in the case of a privately negotiated loan, including a loan to a subsidiary or other related taxpayer. Arkansas BcsL effectively forecloses that argument. Thus, for example, loans made by life insurance companies and other institutional investors, if not engaged in a lending business, are capital assets.

B. Is the Instrument a "security"?

Code Sec. 165(g)(2) defines the term "security" as "(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."13 A debt instrument is considered a "security" for purposes of Code sec. 165 if it is issued with interest coupons or is in registered form.14 Debt instruments with physical interest coupons have not been issued to the public in the U.S. marketplace since the early 1980s, and U.S. issuers generally cannot issue bearer debt, except in certain offerings targeted to foreign persons. Debt is considered to be issued in "registered form" if it can be transferred only on the books and records of the issuer,15 which would include all book-entry securities.16 Thus, as a practical matter, debt that is designed to trade in a secondary market will almost always be in registered form (hence "securities"), while notes issued in private lending transactions frequently are not in registered form (hence not "securities").17

C. Is the Security Completely Worthless?