When worthless is not completely worthless

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(This information may apply to both U.S and Canadian residents. Further enquiries is recommended)

Even if a company is bankrupt and is auctioning off what remains of its assets, that stock may still be listed on the OTC market for pennies. If you owned 100 shares and wanted to unload them to claim your loss, the transaction costs could eat up the entire proceeds and then some.

An alternative would be to dispose of the shares to a brokerage firm. Most brokerages have a general account into which they will take dispositions of non-transferable securities from customer's accounts for a net sale cost of zero. When they do this, they remove the shares from your account and generate a confirmation of the transfer.

You can then use this "confirm" as supporting documentation of the "sale" and that you received nothing as the proceeds. Using this documentation, you can claim the amount of your original cost as a loss. Ask your brokerage firm about their process for disposing of non-transferable securities.

Two guides on selling worthless stocks

The following two links will take you to more detailed informations on turning defunct stocks into capital losses. They are for U.S. residents, but Canadians may find them informative and useful also:

http://invest-faq.com/cbc/trade-worthless-shares.html

http://www.facebook.com/topic.php?uid=26412729952&topic=6097&_fb_noscript=1

Claiming Capital Loss from a Delisted Stock

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(Even though the following info is for Canadians, U.S. residents may find some good ideas to research further)

By FrugalTrader, December 1, 2009
With Nortel becoming delisted, there are thousands of investors out there still holding the delisted stock.  So what happens next?  How do you claim the capital loss?

As I’m not a tax expert, I contacted Tax Guy to help me out with that question.  Here is what he came back with.

If you own shares of a company that are worthless because the company is bankrupt (under the Bankruptcy & Insolvency Act) or is being wound up (under the Winding-Up and Restructuring Act), you can elect to have a deemed disposition and re-acquisition at nil value (essentially you are considered to have sold the shares for $0 and then re-purchased them again for $0).

Even if the company has not officially declared bankruptcy you can still make the election if:  

• The company is insolvent (i.e. it has defaulted on its loans and cannot pay it’s debts);  
• It has ceased operating (this is different than de-listing or ceased trading);   
• The shares have a nil market value (in this case its shares, traded on a stock exchange or not, are worthless); or  
• It is reasonable to expect that the corporation will be dissolved or wound up and will not carry on business in the future

Any of these conditions allow you to claim a capital loss. If the shares ever regain value again, the adjusted cost base (ACB) is $0 and you will have a capital gain when you actually sell them.

A note about de-listing: Just because a stock has ceased trading or has been de-listed from a stock exchange does not itself mean that a deemed disposition can be claimed. It is possible to de-list or cease trading and continue operations.

The Process Of Claiming The Loss
It is important to remember that if you have worthless shares in an RRSP, RRIF or TFSA (registered accounts), then you cannot claim a loss at all.

If the shares were held outside a registered account, then you report the capital loss using Schedule 3 of the Federal Income Tax return. You must also file an election in the form of a written letter indicating that you are claiming a deemed disposition under subsection 50(1) of the Income Tax Act.

There you have it, for all those investors still holding Nortel stock in a non-registered investment account, you can claim the capital loss (assume sold at $0) by using Schedule 3 of the Federal Income Tax Return.

Your defunct "worthless" stocks may not be worthless

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Instead of you going to the library searching through thick volumns of capital-loss tax laws about what to do with defunct stocks, Selena Maranjian has written about this subject for your (U.S. residents') benefit. Here is her informative article:

Make the Most of Worthless Stock
 
At some point, you've probably bought into a promising stock, only to watch it go belly-up. But if you give up and do nothing after your ill-fated holding bites the dust, you could be making a big mistake.

Those worthless shares aren't as worthless as you think. They represent a capital loss, which you can use to offset some of your capital gains on your tax return. If you sold one stock for a $4,000 loss, but reaped a $6,000 gain when selling another, you'll only have to pay taxes on $2,000 of that windfall.

If your worthless company was actually liquidated, you'll face a simple process. Typically, you'll receive a 1099-DIV form at year-end showing a liquidating distribution.Treat this as if you sold the stock for the amount of the distribution. The date of "sale" is the date that the distribution took place. Using your original cost basis in the shares, you can now compute your loss.

Your Uncle Fred could use some new kindling
If the company hasn't actually been liquidated, though, things get a little more complicated. You'll need to make sure your shares are totally worthless before claiming a loss. If so, you can sell the shares through your brokerage -- but sometimes that can be difficult or  expensive. After all, would you want to pay a commission to sell stocks worth $0?

Alternatively, your brokerage might buy the shares from you for a penny. If not, you can sell them to a friend (or cousin, aunt or uncle) for pennies. (Warning: Per tax rules, selling them to a spouse, siblings, parents, grandparents, or lineal descendants won't work.) Here's one way to do it:

   1. Get the actual stock certificates from your broker.
   2. Formally sell the shares to the purchaser, with a check for payment and a bill of sale.
   3. Sign over the stock certificate (on its back) to the purchaser. Have the signatures verified by your banker and/or a local stockbroker.
   4. Send the certificate to the stock transfer agent. Explain that the shares have been sold, and ask them to cancel the old shares and issue a new certificate to the new owner.

By selling the shares, you have a closed transaction with the stock, and you can declare a tax loss. Your friend, relative, or broker -- for a pittance -- has just bought a placemat or a birdcage liner.

Last but not least, you can frame a certificate for worthless shares and hang it in your office, as a reminder to pay more attention to your holdings.

Be proactive
The best way to deal with worthless shares is never to have them in the first place. Keep an eye on swooning shares in your portfolio, and sell any you no longer believe in. Even if they never go out of business, some companies may still cause you grief -- perhaps just by being good, but overvalued, stocks.

The latest fad: claiming a loss. What to do when a firm goes under

(The info here applied to Canada;  U.S. residents may find some ideas for further research)

Arthur Drache, Financial Post, Dec. 03, 2002
All too many of us are becoming familiar with the claiming of capital losses these days.

Problems may arise in situations where there has been no disposition because the security is worthless. And as many readers are aware, there have been an awful lot of companies that have gone bankrupt or have become insolvent while the securities are in investors' portfolios.

Subsection 50(1) of the Income Tax Act attempts to come to grips with this situation. Where the investor holds debt or shares of a company that has become insolvent, he or she can make an election to treat the security as having been disposed of for income tax purposes, thus triggering the capital loss. Normally this is done simply by appending a letter to the return making the claim and making a reference to subsection 50(1).

That having been said, you may be called upon to prove that the company has in fact become bankrupt (which status can be checked with Industry Canada) or is insolvent. The latter status, of course, might be much harder to prove, given that insolvency is not a state which is "registered" anywhere. Data to support your presumption of insolvency should be retained against the possibility of a future tax audit.

If there is an election made under subsection 50(1), the deemed disposition means that the investor continues to own the worthless security and if, by some miraculous change of event, the securities have some value in the future, there is a potential gain which could be subject to tax from an ACB of zero.

Of course, another way to realize the loss is to simply dispose of the shares to a third person. But this too has some technical problems.

First, these days almost nobody gets share certificates that could be "signed off" and transferred to the third party. Presumably, some sort of document might be drawn up evidencing a sale or gift to that person. The technical problem is exacerbated by the fact that given the circumstances, it is almost certain that the change of ownership can never been shown on the books of the company in question -- which is the usual evidence than a transfer has taken place.

Where the shares are held within a portfolio managed by a broker, the recommended step is to have the broker delete the holding from the regular statement of holding. We have been told that some brokers, such as RBC Dominion Securities, will send a letter, if requested, saying that the security has been eliminated from your account because the company is bankrupt or insolvent.

One would hope that in most cases, a claim using the subsection 50(1) election will not be challenged by the Canada Customs and Revenue Agency. But as with all dealings with the tax authorities, it is best not to assume that all will go well and, to be prudent, retain a record of the rationale for the claim until such time as reassessment for that tax year becomes statute barred (usually three years after the date of the initial notice of assessment).