Salvaging Value from Failure: Mastering Section 165(g) Worthless Securities
For high-net-worth investors and venture capital firms, failing investments are an inevitable part of the asset cycle. When a startup or a private company goes bankrupt, the stock becomes "worthless." Under normal rules, this is a capital loss, which can only offset $3,000 of ordinary income. However, Section 165(g) provides a strategic mechanism to characterize these losses more aggressively, especially when the "security" is held in an affiliated corporation. If you can prove that a security became "totally worthless" during the year, and it meets the affiliation tests, you may be able to claim a full ordinary loss deduction against your highest-rate income. Our Venture Advisory Group specializes in timing these "worthlessness events" to maximize tax recovery.
The "Identifiable Event" Burden of Proof
The IRS does not allow you to claim a security is worthless simply because it has lost 99% of its value. To quality for Section 165(g), the value must be zero.
Taxpayers must point to a specific "Identifiable Event"—such as the cessation of business, a bankruptcy filing with no hope of recovery, or a final liquidation—that proves the stock is permanently without value. Furthermore, the loss must be claimed in the *exact* year that worthlessness occurred. Miss the year, and the deduction is lost forever. We provide the forensic documentation required to establish the precise date of loss, utilizing insolvency balance sheet analysis to defend the deduction against IRS "partial worthlessness" challenges.
The Affiliate Exception for Ordinary Losses
While individuals generally take capital losses, corporations that own at least 80% of a subsidiary may qualify for **Section 165(g)(3)** ordinary loss treatment.
This "Affiliate Exception" allows a parent company to fully deduct its entire investment in a failed subsidiary against its other operating income, provided the subsidiary was an active trade or business. For venture capital firms restructuring their portfolio, we architect "Basis-Pushup" strategies and pre-liquidation recapitalizations to ensure the 80% ownership threshold is met before the worthlessness event is triggered. Additionally, for founders of small business corporations, we synchronize 165(g) with Section 1244 ordinary loss limits to protect the first $100,000 of loss from capital treatment.