After the market decline in 2000, 2001 and 2002, many taxpayers have incurred investment losses for worthless securities. Although they may not be able to recover their investment, they may be entitled to a tax deduction.

“We have noticed that even experienced Certified Public Accountants are missing worthless stock loss deductions their clients should be claiming. If you have any questionable stocks in your portfolio, make sure your tax preparer is aware of them and considers taking a loss for them in any year the stock may have become worthless” says Seattle tax attorney, Steven Graham.

To get all the deductions you are entitled to you need to claim all your worthless stock losses, and claim them all in the “right” year. A stock is worthless unless, an informed investor would be willing to pay a more than nominal price for the company’s shares. So if you have stocks in your portfolio (other than stocks you purchased a very low value) that now have a value of less than 25 cents per share, they probably are worthless. However, you have to look at more than price to see if you are entitled to the deduction.

Worthless stock losses are easy to miss because there is often no document to tell you to take the deduction. No sale shows on the report (1099B) from your broker because you can’t sell a worthless stock. The stock continues to appear on the brokerage statement. Some times when trading is stopped, the brokerage statement continues to report the last reported trading price, even though the stock is worthless.

The IRS considers the total situation when deciding whether a stock is worthless. Typical signs that make stock appear worthless are: debts greater than assets, the company filing bankruptcy; or the company selling most of if its assets. Less common signs of worthlessness are: the Company’s inability to obtain credit, a stock being no longer listed on an exchange, the trading of the company’s shares being halted by the SEC.; or a going concern qualification on the company’s audit.

Claiming a loss in the “right” year is important because the IRS allows taxpayers to claim worthless stock losses only in the year the stock becomes worthless. Many taxpayers have lost deductions from the dotcom bust because they either failed to claim the loss, or claimed it in an incorrect year. If the IRS decides the stock became worthless in a different year, you can amend the correct year’s tax return, but usually only for three years after the tax return was filed.

When a stock became worthless may differ from your opinion, or from your tax advisor’s opinion. It is best to try to predict when the IRS would consider your stock worthless. If the IRS and you don’t agree, you may lose your deduction or have to make an appeal, and if the IRS wins they may charge you penalties and interest.

To prove a stock became worthless in a year you must show: (1) an event in the year which either made the stock worthless or showed it was worthless, (2) that the stock had value at the beginning of the year, and (3) by the end of the year there was no reasonable hope or expectation that you would receive any future benefit from the stock in the future.

As an attorney at the Orrick law firm, Mr. Graham is a frequent speaker on securities and corporate law matters, including going public, public company disclosure obligations, and fiduciary obligations of directors.