Bankruptcy creates tax challenges for investors, both shareholders and bondholders. Though the ideal situation is to sell a security before a company files for bankruptcy, once the bankruptcy process starts, investors need to make decisions about what to do with their securities. These decisions are often tied to assumptions based on incomplete information.

In the event of a bankruptcy, the interests of bondholders are favored over those of shareholders. Owners of common stock also see their interests take a back seat to those of preferred stock owners. However, holding bonds does not guarantee priority, as some bonds are “senior,” while others are “subordinate.”

A bankruptcy can result in a reorganization or a sale of the company’s assets. Under a reorganization, bondholders may receive stock in the new company. Shareholders may see their ownership interests completely eliminated. Each bankruptcy is different. Investors need to read the provided documentation to determine what the company’s intentions are and how their stocks or bonds may be affected.

Once the bankruptcy is announced, investors have the opportunity to either sell their holdings or wait for the bankruptcy proceedings to be completed. Selling the security creates a formal capital loss (assuming the security was purchased above its post–bankruptcy announcement price). Waiting for the bankruptcy proceedings to be completed creates the potential to record the holding as “worthless” and claim an even larger capital loss.

Determining If a Security Is Worthless

The tax code states that if any security that is a capital asset becomes worthless during the taxable year, the resulting loss is treated as a loss from the sale or exchange of a capital asset (that is, as a capital loss) on the last day of the taxable year. The same rules apply to securities that are abandoned.

So how do you determine if a security is worthless?

John Kareken, a senior analyst with Wolters Kluwer Financial Services, advises that the security becomes worthless by the IRS when no consideration is offered for it. If there is a market for the security, then, in the eyes of the IRS, it still has value. For example, a company announcing bankruptcy whose stock price is five cents per share, would likely not be viewed as being wholly worthless by the IRS.

Kareken further advises that an investor can wait for the bankruptcy to be completed. If the plan calls for the common stock to be eliminated, shareholders may be able to get an abandonment letter from their broker. Abandonment allows the largest possible capital loss to be realized, thereby maximizing the tax write-off. (Call your broker to find out what their specific procedure is for handling worthless stock.) This often depends on whether a transfer agent still exists to facilitate changes of ownership interest in the stock. Bonds can also be abandoned.

Deadline for Filing

A security, be it a stock or a bond, is counted as worthless by the IRS at the end of the taxable year that the security officially became worthless. This can be the year that the bankruptcy was finalized; however, if the market for the security ceases to exist, it could be sooner. According to Kareken, previous tax returns can be amended to claim a security as worthless, subject to tax deadlines. (Taxpayers generally have three years to amend a return.)

Selling May Be the Easiest Option

The easiest strategy is to sell the security at the prevailing market price. This creates formal buy and sell transactions, simplifying the tax return. Only in situations when you can reasonably expect compensation in excess of the proceeds realized by selling does it make sense to hold onto the security throughout the bankruptcy process. ?

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