By Oz Halabi
A. Understanding Section 165(g) of the Internal Revenue Code of 1986
Section 165(g) of the Internal Revenue Code of 1986, as amended (the “Code”) states that any security which is a capital asset becomes worthless during the taxable year, the loss resulting therefrom shall be treated as a loss from the sale or exchange, on the last day of the taxable year.[1] Accordingly, a taxpayer is permitted to deduct a financial loss attributed to worthless securities in connection with a trade or business, a transaction entered into for profit, or resulting from a casualty or theft. Worthlessness, for purposes of this deduction, is defined as “having no value,”[2] and is only recognized in instances of complete worthlessness; partial worthlessness or mere market fluctuation in value will not qualify.[3] In determining worthlessness, the taxpayer has the burden to provide objective evidence or support of the worthlessness of the security.[4] The deduction is taken during the taxable year that the security became worthless.[5] The security must have some value at the beginning of the year and no value at the end of the year.[6] Moreover, taxpayers who have abandoned their worthless securities are also eligible to receive sale and exchange treatment under Section 165(g) of the Code.
For purposes of the Code, a capital asset is property held by a taxpayer, regardless of whether the property is used in the taxpayer’s trade or business. To be deemed a “capital asset,” the shareholder must hold the security for the requisite “long-term” holding period. A worthless security held for a short-term period is otherwise dealt with under Section 165(a) of the Code.[7] Additionally, those items specifically referenced in Section 1221 of the Code are excluded from the definition of capital assets. To abandon a security, you must permanently surrender and relinquish all rights in the security and receive no consideration in exchange for it.[8]
Furthermore, under Section 165(g) of the Code, the term “security” is defined as (i) a share of stock in a corporation; (ii) a right to subscribe for, or to receive, a share of stock in a corporation; or (iii) a bond, debenture, note, or certificate, or other evidence of indebtedness, issued by a corporation or by a government or political subdivision thereof, with interest coupons or in registered form.[9] Thus, to qualify for a loss deduction under Code Sec. 165(g), the taxpayer’s worthless investment must be both a “capital asset” and a “security.”
B. Is Cryptocurrency a “Security?”
There is much discussion as to whether cryptocurrency should be classified as a security under the purview of Section 165(g) of the Code. Cryptocurrency is a type of virtual currency that utilizes cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain.[10] One approach in determining whether cryptocurrency should be treated as a security is whether it can be regulated by the U.S. Securities and Exchange Commission (the “SEC”). The United States Supreme Court established the “Howey Test” to create parameters for classifying an asset as an “investment contract”; a necessary component to meet the definition of a security. Under the Howey Test, an asset is in an investment contract if there is (1) an investment of money (2) in a common enterprise (3) with a reasonable expectation of profits (4) to be derived from the efforts of others.[11] When applying the Howey Test to cryptocurrency, the critical question is whether cryptocurrency is derived from the efforts of others, or whether its value is akin to a commodity, derived from extraneous factors uncorrelated with any individual’s efforts.
There is no definitive solution, as of yet, although the SEC has advanced several arguments that cryptocurrencies should be regulated as securities. Accordingly, the SEC has commenced actions concerning securities violations involving cryptocurrencies. More recently, in a class action lawsuit filed in the U.S. District Court for the Southern District of Florida against FTX’s management team, it was argued that the yield-bearing cryptocurrency accounts offered by FTX constituted unregistered securities. Alternatively, the U.S. Commodity Futures Trading Commission has treated certain cryptocurrency assets as commodities rather than securities. Nevertheless, the SEC’s extensive oversight over the cryptocurrency industry indicates that the SEC believes that these products should be subsumed under their purview as a “security”.
C. Worthless Securities in a Bankruptcy Event
Under Section 165(g) of the Code, a security is worthless if there is evidence that, under the circumstances, no probability of realization of anything of value from the investment by sale, liquidation, or otherwise thereafter exists.[12] Worthlessness should be fixed by identifiable events, the event, or series of events,[13] should indicate the extinction of value in the stock and that all reasonable hope of even a partial return of capital is gone.[14] In other words, the evidence, borne out by later events, should indicate that, directly after the occurrence of such event, the corporation’s assets are insufficient to permit any distributions to shareholders.[15]
In the context of a bankruptcy event, the cancellation of all of a corporation’s shares under a bankruptcy reorganization plan in exchange for nothing of value in return can potentially satisfy the requirements for worthlessness.[16] In bankruptcy, existing securities will be deemed worthless despite the shareholders’ option to invest additional capital in the post-bankruptcy company’s reorganized business.[17] In contrast, shareholders holding securities for a corporation involved in a bankruptcy event not under a bankruptcy reorganization plan did not receive a deduction because they were unable to establish that the corporation’s stock was worthless.[18]
Is a Crypto Security in Bankruptcy Considered a “Worthless Security”
A “worthless security” requires that such security has no potential to regain value. Cryptocurrency held in an exchange in a bankruptcy proceeding may eventually result in the recovery of some value, as a bankruptcy court may eventually determine the distribution of assets if any are available.
However, a loss may be sustained, if cryptocurrency becomes worthless resulting in an identifiable event that occurs during the tax year for purpose of Section 165(a).[19] Whether the asset has become worthless is a question of fact. In the case of a worthless asset, it is not necessary to relinquish title where there is a “subjective determination of worthlessness in a given year, coupled with a showing that in the such year the asset in question is essentially valueless.”[20] Accordingly, there is a possibility that Cryptocurrency can be considered worthless stock evidence by an identifiable event, however, a determination needs to be made even in bankruptcy as an asset could still potentially be recovered and not be considered worthless security.
[1] IRC § 165(g)(1). Worthless securities are reported to the IRS on Form 8949.
[2] Higginbotham-Bailey-Logan Co, (1927) 8 BTA 566.
[3] Reg § 1.165-5(f); Batson, Horace F., (1983) TC Memo 1983-545.
[4]Boehm, Lillian v. Com., (1945, S Ct) 34 AFTR 10; Bilthouse, Alan v. U.S., (2009, CA7) 103 AFTR 2d 2009-429.
[5] Reg § 1.165-5(e).
[6] Popovich, Andrew, (1965) TC Memo 1965-174; Ellis, Mary, (1947) PH TCM ¶47160, 6 CCH TCM 662.
[7] Reg § 1.165-5(b).
[8] Reg §1.165 –5(i).
[9] IRC § 165(g)(2).
[10] Goldstein, Ronald J., “Applicability of I.R.C. Section 165 to cryptocurrency that has declined in value” Internal Revenue Service Memorandum 202302011 (January 10, 2023).
[11] SEC v. W.J. Howey Co., 328 U.S. 293 (1946).
[12] Watson, John Jr., (1938) 38 BTA 1026.
[13] Rosing, David v. Walter E. Corwin, (1937, CA2) 19 AFTR 135.
[14] Gowen, Albert Y. v. Com., (1933, CA6) 12 AFTR 898; Barbour, Robert, (1939) 39 BTA 553; Jones, Clayton v. Com., (1939, CA9) 22 AFTR 1109.
[15] Drachman, Richard, (1954) 23 TC 558; Camp, Walter A., (1953) PH TCM ¶53273, 12 CCH TCM 908.
[16] Delk, Michael W. v. Com., (1997, CA9) 79 AFTR 2d 97-2483.
[17] Delk, Michael W. v. Com., (1997, CA9) 79 AFTR 2d 97-2483.
[18] Emmer Brothers Co, (1989) TC Memo 1989-338; Delk, Michael W. v. Com., (1997, CA9) 79 AFTR 2d 97-2483.
[19] Goldstein, Ronald J., “Applicability of I.R.C. Section 165 to cryptocurrency that has declined in value” Internal Revenue Service Memorandum 202302011 (January 10, 2023).
[20] Echols v. Commissioner, 935 F.2d 703, 708 (5th Cir. 1991).
