The Part Sale, Part Gift Trap for Nearly Worthless Securities

Editor: Michael D. Koppel, CPA, MSA, MBA, PFS, CITP

Gains & Losses

An investor in corporate shares may on occasion have a significant investment in a business that is experiencing financial problems. Although the outlook is bleak, the doors of the business are still open. The investor would like to realize the potential loss to offset capital gains in the year.

One approach is to claim a loss for worthless securities under Sec. 165 if the stock is wholly worthless. Under Sec. 165, a taxpayer holding stock as a capital asset that becomes worthless during a tax year generally recognizes a capital loss as if the stock were sold or exchanged on the last day of the year. In order to claim a worthless securities deduction for a particular tax year, the taxpayer must show that the stock underlying the claim had a basis and had some value at the beginning of the year but became worthless during the year. To show that a corporation is worthless, the taxpayer must show that the company is balance sheet insolvent and that due to an identifiable event there is no reasonable prospect of realizing any value from the stock in the future. Because of the second requirement, in many cases in which a business has not ceased operations, the taxpayer may find it difficult to prove that stock is totally worthless.

If the stock appears more likely to properly be considered as having some value, the better alternative might be to sell the shares. However, it is important to remember that an investor cannot recognize a loss on a sale to a related person within the meaning of Sec. 267(b). Another hazard for an investor that may be more likely is that the consideration paid by the transferee will be determined to be less than fair market value, making the transaction partly a gift. Regs. Secs. 1.1001-1 and 1.1015-4 set forth the tax consequences of a part gift, part sale transfer. Regs. Sec. 1.1001-1(e) states that, for a transfer that is part sale, part gift, no loss is allowed to the transferor if the amount realized is less than the property’s adjusted basis in the hands of the transferor. If there were a gain, however, the gain would be recognized.

To make matters worse, Regs. Sec. 1.1015-4(a) states that the transferee’s basis for determining gain is:

• The higher of the amount paid by the transferee or the transferor’s adjusted basis, plus
• Any increase for gift tax paid, as allowed by Sec. 1015(d).

The transferee’s basis for loss, however, is limited to the property’s fair market value at the time of the transaction. Accordingly, neither the transferor nor the transferee will be able to recognize the built-in loss on property transferred in a part sale, part gift. However, the transferee could benefit from the transferor’s higher basis, which could reduce the amount of gain the transferee would otherwise realize, if the value of the property increased after the transaction.

If there is any concern that the part sale, part gift rules may apply, the safer course of action would be to claim a worthless security loss. In that case, if complete worthlessness cannot be proved, the loss will be denied, but the taxpayer will not lose his or her basis and “lives to fight another day.”

EditorNotes

Michael Koppel is with Gray, Gray & Gray, LLP, in Westwood, MA.

For additional information about these items, contact Mr. Koppel at (781) 407-0300 or mkoppel@gggcpas.com.

Unless otherwise noted, contributors are members of or associated with CPAmerica International.