When an S corporation’s stock becomes worthless, shareholders are treated as having disposed of their entire interest in the S corporation for passive activity loss purposes, allowing the shareholders to deduct suspended passive losses from the S corporation without regard to the passive activity loss rules. As demonstrated in Bilthouse, No. 05-c-4442 (N.D. Ill. 2007), aff’d, 553 F.3d 513 (7th Cir. 2009), taxpayers and the IRS frequently disagree on when the stock of a corporation becomes worthless.
Alan Bilthouse was a 25% shareholder in an S corporation, S&E Contractors Inc., a heavy construction contractor in Florida that performed public works projects. The company suffered large losses in 1994 and 1995. In 1995, the company became insolvent and defaulted on its construction bonds, and its bonding companies began collecting any subsequent revenues the company generated. S&E filed a lawsuit later that year against the city of Jacksonville, Fla., to try to recoup some of its financial losses from one of its projects with the city. The suit was settled in 1997, but S&E was denied any financial restitution.
In 2001, Bilthouse filed claims for refunds on personal amended returns for 1994 through 1999. Bilthouse contended that his S&E stock became worthless in 1997, resulting in a complete disposition of his interest in the stock per Sec. 165(g). By treating the disposition as occurring in 1997, under Sec 469(g), Bilthouse was able to deduct on the amended returns more than $5 million in accumulated disallowed passive losses that S&E had allocated to him over a number of years. The IRS argued that these claimed deductions were not allowable because Bilthouse’s S&E stock became worthless in 1995, not in 1997. Bilthouse filed a refund suit, but the district court granted summary judgment for the IRS, and the Seventh Circuit affirmed.
Regs. Sec. 1.165-1(b) allows a taxpayer to deduct a loss that is evidenced by a closed and completed transaction, fixed by an identifiable event, and actually sustained in the tax year deducted. If stock is deemed worthless, the loss is deductible as of the last day of the corporation’s tax year (Sec. 165(g)), and any suspended losses from a passive activity are released, since the entity is considered “disposed of” when its stock becomes worthless (Sec. 469(g)).
Even though Sec. 165(g) does not define “worthless,” courts have determined when stock is worthless under various standards relating to the value of a company. In Bilthouse, the Seventh Circuit stated that whether stock was worthless is a facts-and-circumstances inquiry and that most courts look at both the liquidating value and the potential value in making the determination. If there is no liquidating value, the stock could still have potential value and will not be considered worthless if there is a reasonable hope that the company’s assets will exceed its liabilities in the future. The Bilthouse court, citing Keeney, 116 F.2d 401 (2d Cir. 1940), determined that a reasonable hope is one that a reasonable investor, not an “incorrigible optimist,” would have. Merely wishing or hoping that the company will do well in the future is not enough, and the taxpayer must provide objective evidence that the company has potential value.
The Seventh Circuit found that Bilthouse presented no objective evidence that it was reasonable to believe that the lawsuit against the city of Jacksonville would succeed and represented potential value for the company from 1995 until the lawsuit was settled in 1997. Rather, the evidence presented by the IRS showed that any potential value had essentially vanished when the company lost control over its rights to collect revenue. In combination with the bonding companies’ no longer insuring its projects, the company had no way to earn revenue and bid on projects or control the allocation or collection of revenue. Therefore, in 1995, the company had no reasonable means of returning to solvency within the foreseeable future.
In most instances, it is better to take a loss in the earliest year possible, when the taxpayer can file a protective claim for refund. By waiting too long, the taxpayer may be barred by the statute of limitation. Another option a taxpayer may have is to sell the stock, even for a nominal amount, in an arm’s-length transaction. However, this could result in a reduction of the overall loss. Regardless, this option will bypass the worthless security provisions of Sec. 165(g) and make the ensuing losses comply with Regs. Sec. 1.165-1(b). As always, taxpayers considering these alternatives should consult their tax adviser to make sure this is an appropriate strategy given their circumstances.
By John W. McKinley, CPA, CGMA, J.D., LL.M. ( firstname.lastname@example.org ), a lecturer at Cornell University and Ithaca College, and Matthew Kimmey, MBA ( email@example.com ), a tax associate at PwC and a CPA candidate.
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