Part III – Equity Securities

Wash Sales

A wash sale occurs when the same securities are purchased 30 days before or after the sale. If a loss results, all or part of the loss is disallowed. If an equal or greater number of the same securities that were sold are purchased, the entire loss is disallowed. If fewer shares are purchased than were sold, part of the loss is disallowed. The disallowed loss is added to the basis of the securities purchased.

Example 1-total loss disallowed

On February 15, 2013, Joe sold 200 shares of Microsoft for $7,000 that he purchased on July 15, 2010 for $8,500. On March 10, 2013, he purchased 300 shares for $13,500. Joe’s has a $1,500 long-term loss ($8,500 – $7,000) on the sale. But, since he purchased more shares than he sold within 30 days of the sale, the $1,500 loss is disallowed. The basis of the new shares will be $15,000. ($13,500 + $1,500). The basis per share will be $50 ($15,000/300) and his holding period begins on March 10.

Example 2-partial loss disallowed

On February 15, 2013, Joe sold 200 shares of Microsoft for $7,000 that he purchased on July 15, 2010 for $8,500. On March 10, 2013, he purchased 150 shares for $7,500. The loss disallowed is the ratio of new shares purchased to the number sold multiplied times the loss. In this case, the loss disallowed is 150/200 x $1,500 = $1,125. The basis of the new securities will be $8,625. ($7,500 + $1,125). The basis per share will be $ 58,750 ($8,625/150) and his holding period begins on March 10.

Stock Rights

General-Non purchased rights

A stock right gives the holder the privilege of buying additional shares of the same stock owned. When stock sell with the right attached, this is called “rights on”. If you purchase shares during the “rights on” period, you automatically receive the rights. After the “rights on” period expires, the stock does not come with rights. From that time forward, the stock trades “ex-rights”. If you want to buy stock with rights you have to purchase the rights on the open market (this topic is discussed below).

When rights are received for the same shares owned and are proportionate (same number of rights for each share owned), the rights are not taxable. A taxpayer now has two securities-rights and stock. When a stock trades “ex-rights, the rights are traded in the market just as shares of stock are. If the value of the rights at ex-rights date, is less than 15% of the stock value, you can elect to allocate part of the stock cost to the rights. If the value of the rights at ex-rights date is 15% or more of the stock value, you are required to allocate part of the stock cost to the rights. The allocation is based on the formula: fair value of rights divided by (fair value of rights + fair value of stock) multiplied by the cost of stock.

Example 1

Joe owns 500 shares of Yum common stock purchased five years ago for $40 per share (total cost of $20,000). .On July 1, 2013, he receives two rights per share owned allowing him to purchase additional shares of Yum stock at $5 per share exercisable until December 31, 2013. It takes one right to buy one additional share. On July 2, the rights had a value of $5 each [total value of $5,000 (2 x 500 x $5] and the stock $75 (total $37,500). The value of the rights are 13% of the stock value ($5,000 / $37,500). Since the rights value are less than 15% of the stock value, no allocation is required.

Example 2

Assume the same facts as example 1 but the value of the stock is $55. Now, the value of the rights is 18% of the stock value ($5,000 / $27,500). Since the rights value are more than 15% of the stock value, an allocation is required.

The stock cost allocated to the rights will be:

[$5,000 / ($5,000 + $27,500) x $20,000 = $3,000]. The adjusted cost of the stock will be $17,000 ($20,000 – $3,000) or $34 per share ($17,000 / 500). Each right has a basis of $3.00 ($3,000 / 1,000). The holding period of the rights begins on the date received.

Exercise of rights

When rights are exercised, the basis of the stock purchased is the purchase price of the stock plus the amount allocated to the rights. The holding period of the additional shares begins on the acquisition date.

Sale of Rights

If non-taxable rights are sold, a capital gain or loss is realized. The amount depends on whether there was an allocation of the stock cost to the rights. The holding period for the rights sold begins on the stock acquisition date.

Example 1-no allocation made.

Assume the facts in example 1 above. On November 26, 2013, Joe sell all the rights for $5,750. Since the rights have no basis, he has a long-term capital gain of $5,750.

Example 2-allocation made

Assume the facts in example 2 above. On November 26, 2013, Joe sell all the rights for $5,750. Since the rights have a basis of $3,000, he has a long-term capital gain of $2,750.

Purchased rights

These are a capital asset. Their basis is the purchase price and the holding period begins on the date of purchase. If any of the rights are exercised, the basis of the stock purchased is the stock purchase price plus the amount allocated to the rights (see example above). The holding period of the stock begins on the acquisition date.

If the purchased rights are sold, the gain or loss (and short-term or long-term is determined the same way as shares of stock sold.

If the rights lapse, and no allocation of cost was made, there is NO gain or loss. If their was an allocation of cost to the rights, then that amount is a capital loss. The holding period begins on the date the stock was acquired and ends on the date the rights expired.

If the purchased rights become worthless during the year prior to the year they lapse, the holding period ends on the last day of the tax year they became worthless.

Small Business Stock (Sect. 1244)

Even though the small business stock held by a taxpayer is a capital loss, the loss on the sale or worthlessness is treated as an ordinary loss (a gain will be capital gain). The loss deduction is limited to $50,000 ($100,000 on joint return, even if only one spouse has a as Section 1244 loss). The loss is reported on form 4797, Part II. Any amount over the limit is a capital loss reported on form 8949 (the section used depends on whether it is a short-term or long-term).

An ordinary loss is preferable to a capital loss because there is no limit (other than the above and taxable income before the loss deduction). Capital losses in excess of capital gains can only offset can ordinary income only up to $3,000 but the excess can be carried forward. The loss can be claimed only by the original owner of the stock.

If a partnership sells the stock, each partner who were a partner when the stock was issued, will report their proportionate share of the gain or loss on their form 1040 as explained above. If the partnership distributes the stock to its partners, the partners must treat it as a capital loss when they sell the stock.

The Tax Court ruled that shareholders of S corporations must treat the loss as a capital loss when they sell the stock.

To qualify as Section 1244 stock, the following requirements must be met: [J.K. Lasser’s 2014 Your Income Tax].

(1) At the time the stock is issued The corporation’s equity may not exceed $1,000,000, including the stock issued,

(2) The stock must be issued for money or property (other than stock and securities).

(3) The corporation, for the five years preceding the loss on the sale, must have derived more than half of it gross receipts from business operations and not passive income. The five year period is waived if deductions, other than dividends received or NOL, exceed gross income. If the corporation has been in existence for less than five years before the loss on the sale, the time period of existence is used for the gross receipts test.

Sale of Gifts

When a taxpayer sells securities that were received as a gift, the gain or loss and holding period depends on whether they were sold for more or less than the donor’s basis (cost or other basis, plus the gift tax paid). The gift tax adjustment depends on the donor’s acquisition date. If the shares gifted were acquired by the donor between 9/2/58 and 12/31/76, the entire amount of gift tax is added to the donor’s basis. If the shares gifted were acquired by the donor after 12/31/76, a portion of the gift tax is added to the donor’s basis. The amount added is the gift tax paid multiplied by the ratio of the donor’s appreciation in value (value at date of gift less cost) divided by the value at date of the gift, less the annual gift tax exclusion-$13,000 for 2012. The gift tax adjustment applies regardless of a gain or loss on the sale.

If the donor realizes a gain (sales price is more than the donor’s basis), the donee’s basis will be the donor’s basis. The donee’s holding period will be the donor’s holding period (from date of acquisition to date of gift) plus the time held by donee. If the donor realizes a loss (sales price is less than the donor’s basis), the donee’s basis for determining the allowable loss, is the lesser of the fair value of the securities at the date of the gift or the donor’s basis. The reason for using the value at the date of the gift, if it is less than the donor’s basis, is that the donee should not benefit (a greater loss) for a decline in value not suffered by the donee (the donor suffered the loss in value while holding the securities).

The holding period of the securities sold by the donee depends on whether the donor’s basis or value at date of the gift is used for the donee’s basis. If the donor’s basis is used, the holding period begins on the donor’s acquisition date. If the value at the date if the gift is used, the holding period begins on the date of the gift.

Example 1- sale for gain-donor acquisition date before 1/1/76.

Colette purchased 1,200 shares of IBM on 7/1/73 for $30,000. On 10/1/12 she makes a gift of the shares to Jason, her grandson. On that date, the value was $180,000. She paid gift tax of $1,500. The entire $1,500 gift tax is added to Colette’s basis since she purchased the shares before 1/1/76. This makes her adjusted basis $31,500. On 8/1/13 Jason sells all the shares for $192,000. Since the shares were sold for more than the donor’s basis, Colette’s adjusted basis is used for Jason’s basis. Jason has a long-term capital gain of $160,500 ($192,000 – $31,500). Even though Jason held the shares for only 10 months, the gain is long-term because his holding period starts with Colette’s purchase date.

Example 2-sale for gain-donor acquisition date after 12/31/76.

Assume the same facts as Example 1 and the gift tax annual exclusion in 1975 was $8,000. Colette’s gift tax adjustment is the gift tax paid multiplied by the ratio of the donor’s appreciation in value divided by the value at date of the gift, less the annual gift tax exclusion: $1,500 x [($180,000-$30,000) / ($180,000 – $8,000)] = $1,305. Jason’s basis for gain will be $31,305 ($30,000 + $1,305) and his long-term capital gain is $160,695 ($192,000 – $31,305).

Example 3-sale for less than donor’s basis.

On 6/30/2008 Grace purchased 500 shares of Dell for $22,500. On 12/25/2012 she gives them to Joe. At that date, the shares value was $17,500. On 7/31/12 Joe sells the shares for $15,500. Since the value of the shares at the date of the gift was less than Grace’s cost, Joe must use the value at the date of the gift for his basis and the date of the gift is the start of his holding period. Joe has a short-term capital loss of $2 ,000 ($17,500 – $15,500).

Sale of Inherited Property

When a taxpayer sells property received as an inheritance, the basis for determining the recipient’s gain or loss is the fair vale at the date of death or the alternate valuation date, if the executor elects to use that date to value the deceased’s property for the estate tax. There is no adjustment for estate tax paid as there is for the gift tax. When securities are distributed, the executor should always provide the appropriate value. The IRS regulations state that the holding period will always be LONG-TERM, regardless of how long they were held by the deceased and recipient.

Example.

On 7/15/13 John received 1,000 shares of IBM stock from his grandfather’s estate who died 11/15/12. His grandfather purchased the shares for $85,000 in 2002. The executor elected the fair value at date of death for estate tax purposes. At that time, the fair value was $155,000. On 12/27/13, John sold 500 shares for $175 per share (total $87,500). John will report a long-term capital gain of $10,000 [$87,500 – (500 / 1,000 x $155,000)]. Note that even though John held the shares for only five months, the holding period is still long-term. If John sells the shares for $70,000, he will report a long-term loss of $7,500 ($77,500 – $70,000). His basis in the remaining 500 shares is $77,500 (1/2 x $155,000). Basis per share is $155 ($77,500/500).

Non-Business Bad Debts

A non-business bad debts is treated as a short-term capital loss, regardless of how long it has been owed to the creditor. The debt must be bona fide. If the creditor cannot substantiate that the debt is bona fide, and reasonable efforts were made to collect it, the IRS may consider it as a gift and no deduction will be allowed. This is particularly true for debts involving related parties. To be able to substantiate and validate the debt, the debt agreement should be in writing and signed and dated by the debtor and creditor. The creditor should have documentation (such as letters and records of phone calls to the debtor) for attempts to collect it. A very good way to document the worthlessness of a debt is to obtain a court judgment against the debtor and show proof of follow-up attempts to collect the judgment. Non-business debts are not limited to loans. They could be for amounts paid on behalf of another person.

Example.

On February 15, 2012, Harold purchased a computer for $1,200 for his friend Barb and made $100 monthly payments for 12 months. There was a written agreement that Barb would repay the amounts that he paid starting in July 2012. Harold had copies of the cancelled checks for the payments. Barb did not make the payments despite many oral and written requests. On September 15, 2013, Harold sued her in small claims court and obtained a judgment for $1,200. Despite many attempts to collect the judgment Barb did not pay him. Harold was able to document the legitimacy of the debt by the written repayment agreement, cancelled checks for payments made, and letters requesting payment. Harold can take a $1,200 short-term capital loss in 2013.

Note: even though the debt agreement was held for 19 months (February 2012 to September 2013), the loss is still a short-term capital loss per IRS regulations.

The creditor could have a partial loss if any amount has been collected from the debtor or a collection agency. If the creditor takes a capital loss for part or all of the debt and in a later year collects part or all of it, the amount recovered must be reported as ordinary income in the year received.

Worthless Securities

A corporation may go out of business and it securities become worthless. This results in a capital loss equal to the taxpayer’s basis in the securities less any recovery. Regardless of when during the year the loss became evident, the holding period ends on the last day of the tax year in which the security became worthless.

In accordance with Circular 230 Disclosure