Worthless Startup Stock: Deducting Shares, Options and Loans

Writing off worthless startup stock: the rule

Shares in a failed startup are deductible in the tax year they become completely worthless. The law treats them as sold for nothing on the last day of that year, so the loss is normally a capital loss (26 U.S.C. 165(g)). Capital losses first offset capital gains, then up to $3,000 of other income a year ($1,500 married filing separately); the rest carries to later years (Schedule D instructions).

Two rules can do better or worse than that:

• Section 1244 turns up to $50,000 a year ($100,000 on a joint return) into an ordinary loss that offsets wages in full, but only for stock the company issued to you for money or property while it was small (26 U.S.C. 1244).
• A loan to the company that goes bad is usually a short-term capital loss, and only if it was a real debt (26 U.S.C. 166(d)).

A case stops being simple when the year of worthlessness is arguable, the loss is large enough that ordinary versus capital matters, you hold several kinds of stock or options, a merger paid others but not you, you live outside the US, or you missed the year. Gather:

• Stock purchase agreements, share certificates or cap table records, and any 83(b) election
• Option exercise notices, wire or check records, and the W-2 or Form 3921 for the exercise
• Proof of what the company received for all its stock, from its records or returns
• Dissolution, bankruptcy, asset sale or merger papers, and the final notice to stockholders
• Signed loan notes, wire records and your collection efforts

When is startup stock worthless, and which year do I claim the loss?

Claim the loss in the year an identifiable event shows the stock has no value left, not the year the company started struggling. A deductible loss must be fixed by identifiable events and closed transactions in that year (26 CFR 1.165-1(b) and (d)). A drop in value, however steep, is not deductible while any value remains (26 CFR 1.165-5(f)).

Events that tend to fix the year include the company ceasing business with debts above its assets, a bankruptcy or dissolution leaving nothing for stockholders, or a sale of its assets that pays creditors and preferred holders but leaves nothing for your class. Which event counts is a question of facts, and the IRS can argue for an earlier or later year.

You can also abandon the shares: permanently give up all rights in them for nothing in return. The IRS treats abandoned securities as worthless securities (Publication 550). Whether a transfer is really an abandonment depends on all the facts.

The loss is dated the last day of the tax year. That date, not the day the company shut, decides whether you held the shares more than one year and the loss is long-term.

What can I deduct: cash for shares, the exercise price, income already taxed?

The loss equals your basis in the shares: what you paid plus any amount already taxed as income when you got them (Publication 525).

If you paid for shares with a negotiable promissory note and the stock becomes worthless, a cash-method taxpayer deducts the note payments in the years they are paid, not in the year of worthlessness (Publication 550). For tax still owed on an exercise, or getting AMT back, see tax on stock options that lost value.

Is a worthless stock loss capital, and how much can it offset each year?

Without section 1244, yes: a worthless share is a capital asset treated as sold, so the loss is capital (26 CFR 1.165-5(c)). It offsets capital gains in full, then up to $3,000 of wages and other income each year ($1,500 if married filing separately). The unused part carries forward to later years (Schedule D instructions).

QSBS (section 1202) excludes gain on qualifying stock; it adds nothing to a loss. See QSBS for founders and early employees.

This page covers the federal return. Each state sets its own rules, so check your state's treatment of capital losses and section 1244.

Section 1244 stock loss: does my stock qualify, and up to how much?

Section 1244 makes a loss on qualifying stock an ordinary loss, up to $50,000 a year, or $100,000 on a joint return even if only one spouse has the loss. Any excess is a capital loss (26 U.S.C. 1244(b); Publication 550). The stock must meet every test:

Preferred stock can qualify; the statute dropped its common-only rule, though an older regulation still says common (Publication 550). In the year a company's capital receipts first pass $1,000,000, it designates which shares issued that year qualify; shares issued in later years do not (26 CFR 1.1244(c)-2(b)).

Money you later put in as a capital contribution raises your basis but counts as non-section-1244 stock, so that part of the loss is capital (26 U.S.C. 1244(d)(1)(B)). An ordinary loss under section 1244 is treated as a business loss for the net operating loss rules, so a loss larger than your income can carry forward (26 U.S.C. 1244(d)(3)).

Do founder shares, exercised options, SAFEs or angel investments qualify for section 1244?

Each depends on what you gave the company for the shares and how much it had raised by then.

• Founder shares bought for cash can qualify for the cash paid. Shares received for services do not, even if you paid tax on them under an 83(b) election (26 CFR 1.1244(c)-1(d)). Shares received for code or other property can qualify, but the loss is limited if the property's basis was above its value (26 U.S.C. 1244(d)(1)(A)).
• Exercised options: the exercise price is money paid to the company, but the shares also come from a grant for services. How much, if any, of the loss qualifies is not spelled out in the statute or regulations; get advice before claiming it. Shares exercised after the company passed $1,000,000 in capital receipts do not qualify.
• SAFEs and convertible notes are not stock while unconverted, so section 1244 cannot apply to them. After conversion, stock issued in exchange for stock or securities does not qualify; stock issued for cancelling the company's debt counts as issued for money or property unless the debt was itself a security or was owed for services, such as unpaid salary (26 CFR 1.1244(c)-1(d)). How a converted SAFE fits these rules is not settled, and a priced round usually takes the company past $1,000,000. The tax treatment of a SAFE that never converted is not settled by IRS guidance.
• Angel investments bought directly from the company for cash can qualify if the company was still under $1,000,000 at that issue. Shares bought from another holder in a secondary sale never qualify.

Can I deduct money I lent the company?

Yes, if it was a genuine loan and it became totally worthless in the year you claim it. For a founder or investor, it is usually a nonbusiness bad debt, deducted as a short-term capital loss (26 U.S.C. 166(d); IRS Topic 453). It is a business bad debt only if the loss is proximately related to a trade or business you carry on, which the regulation calls a question of fact (26 CFR 1.166-5(b)); a loan or guarantee made to protect your investment in the company is a nonbusiness debt (Publication 550). A partly worthless nonbusiness debt is not deductible.

A debt is genuine when there was a valid, enforceable obligation to repay a fixed or determinable sum and you intended a loan, not a gift (Publication 550). A signed note, a repayment date and interest support that. Money put in with no note and no expectation of repayment may instead be a capital contribution, which adds to your stock basis.

• A note issued in registered form or with interest coupons is a security; when worthless, it is a worthless-security capital loss dated the last day of the year, not a bad debt (26 U.S.C. 165(g)(2)(C) and 166(e)).
• If you personally guaranteed a company loan to protect your investment and paid it, the payment can be a nonbusiness bad debt, generally in the year you pay, unless you still have rights to collect from the company (Publication 550).
• Loans are never section 1244 stock.

What if a merger paid the preferred holders and nothing to common?

The common holder generally has a capital loss equal to basis, fixed by the merger itself in the year it closes (26 CFR 1.165-1(d)). Section 1244 covers a sale or exchange as well as worthlessness, so qualifying stock can still give an ordinary loss (26 CFR 1.1244(a)-1).

Whether the loss is reported as an exchange for nothing on the closing date or as a worthless security on the last day of the year can change the holding period. Read the merger agreement: if your shares were cancelled, converted into buyer stock, or left outstanding in a company that still has value, the answer differs. Any cash or stock you did receive reduces the loss. For how a company with cash left pays its holders, see returning cash to investors when a startup closes.

How do I report it: Form 8949, Schedule D and Form 4797?

The form depends on the kind of loss.

A bad debt needs a statement attached to the return: the debt's amount and due date, the debtor's name and any business or family relationship, your efforts to collect, and why you decided it was worthless (IRS Topic 453). For a large or arguable worthless stock loss, a short statement of the event that made the stock worthless also helps.

I missed the year: how far back can I amend?

For a worthless security or a bad debt, you have 7 years from the original due date of the return for the year it became worthless, or 2 years from when you paid that year's tax if later (26 U.S.C. 6511(d)(1); Publication 550). File Form 1040-X for that year. Other refund claims generally have only the shorter window of 3 years after filing the original return or 2 years after paying the tax, whichever is later. That includes a loss fixed by a merger or sale for nothing, which is an exchange, not worthlessness.

The longer window also covers the loss's effect on a carryover to later years. Because the right year is often arguable, the longer window leaves room to correct a claim made in the wrong year, but the right year still has to be proven.

What records prove the loss?

Keep proof of basis, of the event, and, for section 1244, of how the company issued its stock. You must keep records showing your stock qualifies and separating it from any other stock you own in the company (26 CFR 1.1244(e)-1(b)).

• Basis: purchase or exercise agreements, wire records, the 83(b) election, W-2 or Form 3921.
• Section 1244: the company's record of who received stock, when, and for what; total money and property received for all stock; its returns showing sources of gross receipts (26 CFR 1.1244(e)-1(a)). Ask for these before the company is dissolved.
• Worthlessness: board minutes, dissolution or bankruptcy filings, the final stockholder notice, asset sale or merger agreement.
• Loans: the signed note, wire records, demand letters, and proof the company could not pay.

Example

All figures are in US dollars and illustrative.

Married founder with section 1244 stock

• Year 1: a founder pays $80,000 cash for common shares. Counting that payment, the company has received $200,000 for all its stock.
• Year 6: the company dissolves with nothing left for stockholders, and its deductions exceeded its gross income every year.
• Filing jointly, the founder may claim the full $80,000 as an ordinary loss on Form 4797, against wages. Without section 1244, it would be a capital loss limited to $3,000 a year after gains.

Engineer with exercised options

• Year 1: an engineer filing single pays $20,000 to exercise incentive stock options, after the company has raised several million dollars, so section 1244 does not apply.
• Year 3: the company winds down and the shares become worthless: a $20,000 long-term capital loss.
• With no capital gains, $3,000 offsets wages each year and $17,000 carries to year 4, $14,000 to year 5, and so on until used.

Founder loan

• Year 1: a founder filing single lends the company $50,000 under a signed note with a repayment date.
• Year 2: the company closes, owing more than it has, and pays nothing on the note.
• The $50,000 is a short-term capital loss in year 2, reported on Form 8949 with a bad debt statement. It offsets any capital gains first, then $3,000 of other income, with the rest carried forward.

Different for you?

• You owe tax from exercising options on now-worthless shares, or want AMT back: see tax on stock options that lost value.
• The company still has cash to pay out: see returning cash to investors when a startup closes.
• You are closing the Delaware corporation yourself: see dissolving a Delaware corporation.
• You live in Canada: see closing a US startup as a Canadian founder.
• You need your basis after an 83(b) election: see reporting founder stock and the 83(b) on your return.
• The loss is large, the year is arguable, you missed the year, or section 1244 turns on how your shares were issued: these need a judgment call on facts and records; see individual tax.