Taxpayer can deduct worthless stock - if he can live long enough

A recent decision of the Tax Court demonstrates a tax risk sometimes encountered by employees of enterprises that have the potential for becoming financially unstable.

This case (Patrick J. Sheedy and Karen J. Sheedy v. Commissioner, T.C. Memo 2012-69, March 14, 2012) also reinforces the importance of fully understanding the tax consequences of exercising stock options.

Patrick Sheedy was an employee of People's Choice Financial Corp. (PCFC) from October 2001 through June 2006. In December 2004, Sheedy was awarded nonqualified options to purchase over 270,000 shares of PCFC at approximately 2 cents per share.

The options would expire three months after Sheedy terminated his employment with PCFC. After leaving the company in June, Sheedy exercised options in September 2006 to acquire 250,000 shares of PCFC stock. He paid about $5,500 to exercise the options.

PCFC stock traded over the counter. The day before Sheedy exercised his options, 6,900 shares traded at $3 per share. In mid-October 2006, 254,800 shares traded at $3 per share.

Sheedy's shares were valued at $3 per share at the date of exercise, and his taxable compensation was calculated as the difference between the $3-per-share fair market value and the approximately 2-cents-per-share exercise price. His income from the option exercise amounted to almost $745,000. To cover the withholding taxes on the taxable income from the option exercise, Sheedy provided to the company almost $220,000.

Over the next several months, Sheedy unsuccessfully attempted to sell his PCFC shares. In March 2007, PCFC filed for bankruptcy protection.

The IRS determined that, at the date Sheedy exercised his options, the PCFC stock was worth $3 per share and that he recognized taxable income of almost $745,000. The court agreed.

The IRS did concede that the stock became worthless in 2007. It allowed Sheedy a worthless stock deduction, which resulted in a capital loss carryover to 2008 of $747,000.

A capital loss can be used only to offset capital gains, with a $3,000 annual deduction for a capital loss in excess of capital gain income for each year. So, unless Sheedy generates significant future capital gain income, it will take 249 years to deduct the $747,000 capital loss carryover at the rate of $3,000 per year.

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