If you have equity in a startup that shut down, you can claim it as a loss on your taxes. But, it's not as simple as just writing them off as a total loss when you find out about it – the IRS wants you to claim the loss in the year the stock became worthless. Not before, not after. The challenge is determining exactly when your stock became worthless since filing for bankruptcy or shutting down operations doesn’t necessarily make the stock worthless. It’s a good idea to work with a CPA or EA to ensure accurate reporting of worthless stock,
How to Claim a Loss on Worthless Securities
Worthless stock is reported as a sale on Form 8949 (Sales and Other Dispositions of Capital Assets) and is either considered a short-term or long-term capital loss based on how long you held the shares. There may also be an ordinary income or AMT component to account for, depending on the kind of equity you own.
Regardless of when your shares actually became worthless, they’re considered sold on the last day of that year. In other words, if your shares became worthless on any day in 2023, you’d report them as sold on December 31st, 2023. It’s crucial to keep records that support your claim since your stock wasn’t actually sold. The IRS doesn’t let you choose what year to claim a loss – it has to be in the year the loss occurred (barring any special exceptions).
Keep in mind, you can still claim a loss even if you already filed your taxes for that year. You’ll need to file an amended return using Form 1040-X to report the loss and claim a refund. The deadline to file a claim for a refund is usually 3 years from the date you filed your return or 2 years from the date you paid the tax, but for worthless securities, you have up to 7 years after filing your return.
The extended deadline for filing for a refund can be very helpful, especially if your old company closed down quietly, you didn’t know how to claim a loss on worthless shares before filing your original return, or you’re having trouble figuring out exactly when your shares became worthless.
Arguably worse than writing off worthless shares as a total loss is getting stuck in “loss purgatory”. This is when your company is still around, but it just kind of... exists. There’s no liquid market for the shares, no optimism of future success, and no liquidity event in the foreseeable future. You can’t sell your shares, but your shares aren’t worthless either (even if you think they are), so you can’t even write them off as worthless and at least get some tax benefit out of it. You might’ve heard of the term “zombie startups”. That’s what this is.
Since 2008, the IRS does let you abandon securities to establish worthlessness, but don’t get too excited about that as a way to escape loss purgatory. VC-backed startups that grant options and RSUs are C-corporations, and you can’t just decide to abandon your equity in a corporation (corporate debt, partnership share, and LLC ownership have different rules).
To really cut your losses and give up any hope for a turnaround, you need to find someone to buy your shares. Ideally, you can convince your company to buy back your shares to lock in your loss, but if they refuse to buy your shares for an insignificant amount, you’d have to find someone else to buy them.
If someone ultimately does buy back your shares, it’s no longer considered a write-off of worthless securities, so you’ll report the sale as you normally would. In other words, the sale date is the actual date you sold your shares and not the last day of the year.
How Sales of Equity Compensation are Treated
Unless you meet an exception where your loss is treated differently, here’s an overview of how some common types of equity compensation are treated when sold:
Incentive Stock Options (ISOs) – Qualifying Disposition:
A qualifying disposition is one where the sale happens more than 2 years after the grant date of your ISOs and more than 1 year after you exercise your ISOs.
Your cost basis for capital gains/loss purposes is your exercise price, and your cost basis for AMT purposes is the fair market value (or FMV – usually the 409a valuation for private companies) on the date you exercised the ISOs. The difference between your cost basis and sale price is your gain or loss, and the difference between your AMT cost basis and sale price is your AMT gain or loss. You must calculate both your regular gains/losses and AMT gains/losses, and you may report a negative AMT adjustment on line 2k (Disposition of Property) of Form 6251.
It’s important to note that if you have a capital loss or AMT loss, the amount of loss that can be claimed in the current year may be limited, with any excess losses carried forward to future tax years. This can also force the negative AMT adjustment in the current year to be smaller than expected.
Incentive Stock Options (ISOs) – Disqualifying Disposition:
A disqualifying disposition occurs when you don’t meet both requirements for a qualifying disposition.
Your cost basis is the FMV on the date you exercised the ISOs or your exercise price, whichever is higher. The difference between your cost basis and sale price is your gain or loss.
However, if the exercise and disqualifying disposition occur in different tax years, you must calculate the AMT impact in both the exercise year and the sale year. Proper tax reporting for this situation is more complicated than same-year disqualifying dispositions, so consider consulting a CPA or EA with equity compensation expertise.
A Special Case - Disqualifying Disposition of Early-Exercised ISOs:
Your cost basis is the FMV on the date your ISOs vested (not the FMV on the date you exercised the ISOs) or your exercise price, whichever is higher. This is true even if you filed a timely 83(b) election. The difference between your cost basis and sale price is your gain or loss.
Nonqualified Stock Options (NSOs):
Your cost basis is the FMV on the date you exercised your NSOs. The difference between your cost basis and sale price is your gain or loss.
Restricted Stock Units (RSUs):
Your cost basis is the FMV on the day your RSUs vested. The difference between your cost basis and sale price is your gain or loss.
Restricted Stock Awards (RSAs):
Your cost basis is the FMV on the day your RSAs vested. The difference between your cost basis and sale price is your gain or loss. However, if you made a timely 83(b) election when your shares were granted, your cost basis is instead measured on the date of your 83(b) election.
Employee Stock Purchase Plan Shares (ESPP):
ESPPs have the most complicated set of tax rules, since the timing and characterization of taxes are dependent on whether your ESPP is a qualified or nonqualified plan, whether the sale is a qualifying or disqalifying disposition, the discount applied to the purchase price, and more. This post discusses the taxation of ESPP shares in depth.
Worthless startup equity can be reported as a sale on Form 8949 as of the last day of the year they became worthless. Records should be kept to support the timing and amount of the loss since the stock wasn't actually sold.
If you already filed your tax return for that year, you can file an amended return to report the loss and claim a refund, with a deadline of 7 years after filing your original return.
Although the IRS allows the abandonment of securities to establish worthlessness, this may not be possible for C-corporation shareholders. If your shares can’t be sold and can’t be abandoned, you could get stuck in “loss purgatory” and be unable to claim a loss.
Different types of equity compensation have different tax implications. Consider consulting a CPA or EA for proper tax reporting.