Unfortunately, debt and equity investments are sometimes a complete bust.
Although, perhaps more common and closely held businesses,
no enterprise or industry is immune to insolvency.
In this lesson, you will learn about the tax implications
of investor losses due to worthlessness of
debt and equity investments as well as bad debts resulting from
the extension of credit to corporations that later become insolvent.
After learning these new concepts,
you apply them to Sunchaser Shakery.
Let's examine worthless debt and equity investments.
If stocks and bonds are capital assets to their owners,
that is held for investment,
losses from their complete worthlessness are governed by Code Section 165 G1.
But before we look at this code section,
let's think about what you've learned so far.
Why would a special code section be needed in this circumstance?
Wouldn't the amount realized simply be zero resulting in
a realized loss equal to the investors adjusted basis in the investment.
Makes sense but there's a catch.
Technically, a transaction is not realized unless there is
a measurable change in property rights to the investment that is now deemed worthless.
Would you like to buy some Enron stock? No you wouldn't.
Thus without a special rule,
an investor may never realize a loss on
a worthless investment because very few would
ever want property rights to a worthless investment.
For this reason section 165 G1 states that if
any security which is a capital asset becomes worthless during the taxable year,
the loss resulting from shall,
for purposes of this subtitle,
be treated as a loss from the sale or
exchange on the last day of the taxable year of a capital asset.
Paragraph two defines the term security as a share of stock,
a right to subscribe to a share of stock or a bond,
note or other form of indebtedness issued by corporation.
In other words, a capital loss results on the last day of
the tax year in which a debt or equity investment becomes worthless.
Note that this provision applies to
complete worthlessness not a partial decline in value.
The burden of proving complete worthlessness is on the taxpayer not the IRS.
If an investment is partially worthless,
one way for an investor to realize and recognize
such loss is to sell the investment at fair market value to an unrelated party.
Keep in mind that stocks and bonds can be
ordinary assets rather than capital assets to some taxpayers.
For example, if an investment broker holds
stocks as inventory in hopes of selling them to clients,
the loss on the worthlessness of such stock receives ordinary loss treatment.
Similarly, in the case of an affiliated corporation,
an ordinary loss may be allowed for worthless investments.
Recall that a corporation is an affiliate of
another corporation if the corporate shareholder owns at least 80 percent
of the voting power of all classes of stock in time to
vote and 80 percent of each class of non-voting stock.
Further, the corporation must have derived
more than 90 percent of its aggregate gross receipts for
all tax years from sources other than passive income which includes rents,
royalties, dividends, and interest.
Aside from worthless debt and equity investments,
insolvency can result in bad debts to those
who have previously extended credit to the corporation.
Any deductions for such bad debts are
classified as either business or non-business bad debts.
The distinction between the two is important because each has a different tax treatment.
Business bad debts are deducted as ordinary losses
while non-business bad debts are short term capital losses.
A business bad debt can create a net operating loss while a non-business bad debt cannot.
A deduction is allowed for the partial worthlessness of a business bad debt
but non-business bad debts can only be written off and completely worthless.
As a general rule, non-business bad debt treatment is limited to non-business investors.
That is if a non-business investor such as an individual extends credit to a corporation,
any bad debt is generally viewed as non-business in nature.
Likewise, if a corporation extends credit to another corporation,
any bad debt is viewed as a business bad debt.
These general rules stem from Whipple et al V. Commissioner,
where the US supreme court held that if an individual shareholders
lend money to a corporation in their capacity as investors,
any resulting bad debt is considered non-business.
However it is important to note that the court did not preclude
the possibility of a shareholder creditor incurring a business bad debt.
So at the end of the day, how does one determine
whether a debt is business or non-business?
It depends. But for purposes of this course,
follow the general rule.
Michael P Donohoe, PhD, CPAAssociate Professor of Accountancy and PwC Faculty Fellow
