How to Report Worthless Stock on a Tax Return?

Discovering that a stock in a client’s portfolio is now completely worthless can feel like a sunk cost with no silver lining. However, from a tax perspective, that loss is a valuable asset if you know how to report it correctly. This guide provides a detailed walkthrough of the process, covering how to prove a stock is worthless, the critical timing rules, and the step-by-step instructions for reporting it on a tax return.

First, Prove the Security is Completely Worthless

The first and most important step is confirming the stock has zero value. The IRS has a high standard for declaring a security worthless; a significant drop in price isn't enough. The stock must be completely and permanently valueless, with no hope for recovery. To prove this, you need to be able to point to a specific "identifiable event" that clearly marks the moment the investment was lost.

An identifiable event is an objective action or circumstance that solidifies the loss. Common examples include:

• Bankruptcy: A company filing for Chapter 7 bankruptcy is a strong indicator of worthlessness, as this process involves liquidating all assets to pay creditors, leaving nothing for stockholders. Be careful with Chapter 11 bankruptcy, which is a reorganization—the company may continue operating and the stock could retain some value.
• Liquidation: A formal resolution by the company to liquidate its assets and dissolve the business is a definitive event.
• Cessation of Business Operations: If the company stops all business activities and abandons its assets, this can serve as an identifiable event.
• Corporate Charter Revocation: The state revoking or terminating the company's charter effectively ends its legal existence.

The burden of proof falls on the taxpayer, so documentation is key to building a defensible position. You can find evidence by searching for SEC filings (like a Form 8-K announcing bankruptcy), checking for delisting notices from exchanges like the NYSE or NASDAQ, or finding official company press releases announcing business termination. Keep records of these documents with the client’s tax files.

Timing is Everything: When to Claim the Loss

Once you’ve confirmed the stock is worthless and identified the event that caused it, the next step is determining when to report the loss. This is where a special tax rule comes into play that often confuses people.

Under IRC Section 165(g), a security that becomes worthless during the tax year is treated as if it were sold on the last day of that tax year. This rule establishes a clear, consistent "sale date" for determining the holding period and classifying the loss.

Let's look at an example. Suppose a client bought 100 shares of XYZ Corp. on June 10, 2023. On April 5, 2024, XYZ Corp. formally declares Chapter 7 bankruptcy and ceases all operations. Even though the stock became worthless in reality on April 5th, for tax purposes, the sale is deemed to have occurred on December 31, 2024.

This timing rule is fundamental because it determines whether the loss is short-term or long-term. The holding period runs from the original acquisition date to this deemed sale date of December 31st.

• Short-Term Capital Loss: Held for one year or less.
• Long-Term Capital Loss: Held for more than one year.

In our example, the client's holding period is from June 10, 2023, to December 31, 2024—a period of more than one year. Therefore, the client has a long-term capital loss, even though the company went under less than a year after the purchase. This distinction is important for properly completing the tax forms.

Calculating the Correct Loss Amount

The amount of the deductible loss is the taxpayer's adjusted basis in the stock. For most simple purchases, the basis is the original purchase price plus any transaction fees or commissions paid at the time of purchase. However, the basis can become more complex in other scenarios.

Here are a few common situations that can affect a stock's basis:

• Reinvested Dividends: If the client enrolled in a dividend reinvestment plan (DRIP), each dividend that was used to purchase more shares increases the total basis of the investment. You must track each of these small purchases to calculate the basis accurately.
• Stock Splits and Stock Dividends: A stock split doesn't change the total basis, but it requires you to reallocate the original basis over the new, larger number of shares.
• Inherited Stock: For inherited stocks, the basis is typically "stepped up" (or down) to the fair market value of the stock on the date of the previous owner's death. The original purchase price is no longer relevant.

For example, if your client purchased 100 shares for $5,000 (including commissions) and later had $500 in dividends automatically reinvested to buy more shares, their total adjusted basis would be $5,500. This is the amount they can claim as a capital loss.

How to Report the Loss on Your Tax Return

Worthless stock losses are reported using two main forms: Form 8949, Sales and Other Dispositions of Capital Assets, and Schedule D, Capital Gains and Losses. Here is a step-by-step breakdown of how to fill them out for a worthless security.

Step 1: Complete Form 8949

This form is where you detail each individual capital asset transaction. You'll use either Part I for short-term losses or Part II for long-term losses, based on the holding period you determined earlier.

Fill out the columns as follows:

• (a) Description of property: Enter the number of shares and the company name (e.g., "100 shares of XYZ Corp.").
• (b) Date acquired: Enter the original purchase date. If shares were bought on multiple dates, you may need to list them as separate transactions.
• (c) Date sold or disposed of: This is the key part. Enter the last day of the year the stock became worthless (e.g., "12/31/2024"). Do not use the date of the identifiable event.
• (d) Proceeds (sales price): Enter $0 or leave it blank. Since the stock is worthless, there are no proceeds.
• (e) Cost or other basis: Enter a client's adjusted basis. This represents the total investment lost.
• (f) Code(s): Many preparers enter "WORTHLESS" here to explain to the IRS why the transaction is being reported with zero proceeds without appearing on a Form 1099-B from a broker.
• (g) Amount of adjustment: This column is generally left blank for this type of transaction.
• (h) Gain or (loss): Calculate the loss by subtracting the proceeds ($0) from the basis. The result will be a negative number equal to the client's basis.

Step 2: Transfer Totals to Schedule D

After completing Form 8949, the summary totals are carried over to the corresponding lines on Schedule D. The worthless stock loss will be combined with any other capital gains and losses the client had during the year.

Remember the loss limitation rules. Taxpayers can deduct a net capital loss of up to $3,000 ($1,500 if married filing separately) against their ordinary income each year. Any loss exceeding this limit can be carried forward to subsequent years until it is fully used.

Special Cases: Affiliated Corporations and Small Business Stock

While most worthless stock results in a capital loss, a few specific situations allow for the much more beneficial treatment of an ordinary loss. Ordinary losses are not subject to the $3,000 annual limit and can offset all types of ordinary income, such as wages, bonuses, and interest.

Worthless Stock in an Affiliated Corporation
If a C corporation owns stock in an "affiliated" subsidiary that becomes worthless, the parent company may be able to claim an ordinary loss instead of a capital loss. For two corporations to be considered affiliated under IRC Section 165(g)(3), the parent must directly own at least 80% of the subsidiary's voting power and 80% of the total value of its stock. Additionally, more than 90% of the subsidiary's gross receipts for all its tax years must come from active business operations, not passive-income sources like royalties or interest.

Section 1244 Stock
Another exception applies to "Section 1244 stock," which is stock issued by a qualified domestic small business corporation. Individuals who are the original recipients of this stock can treat a loss from it becoming worthless as an ordinary loss. The annual limits for this treatment are $50,000 for single filers and $100,000 for those married filing jointly. Any loss beyond these thresholds is treated as a standard capital loss.

Final Thoughts

Transforming a worthless stock into a deductible tax loss requires a careful and methodical approach. You must prove worthlessness through an identifiable event, apply the special timing rule that treats the sale as occurring on the last day of the year, calculate the adjusted basis correctly, and report the transaction on Form 8949 and Schedule D.

When you're dealing with specific code sections like IRC §165 or §1244, getting precise answers quickly is essential for providing confident client advice. We designed Feather AI to deliver instant, citation-backed responses to complex tax questions, ensuring that your work is always built upon authoritative sources. Instead of spending hours searching through IRS publications and court cases, you can get the information you need in seconds to make the best decisions for your clients.