You should issue cancellation of debt forms for the 2009 tax year (late now, but you have to write off bad debt in the year it becomes worthless as a short term capital loss... do this on the partnership return and let it flow through to your individual 1040 returns).
The same goes for the capital stock as a worthless security (treated as sold on the last day of the tax year it becomes totally worthless... long term loss for you).
Talk to a local professional about proving the timing of your deductions (ie., when did the company quit answering the phone, did the company file BK, etc?... you are looking for documentation to meet your substantiation requirements)
See Form 1099-C - Cancellation of debt (issued by lenders who forgive debts and call the debt worthless for tax purposes):
Pay attention to the Section 1244 loss rules!!, here, to see if they will apply on the worthless stock:
How Current is This?
(a) General rule
In the case of an individual, a loss on section 1244 stock issued to such individual or to a partnership which would (but for this section) be treated as a loss from the sale or exchange of a capital asset shall, to the extent provided in this section, be treated as an ordinary loss.
(c) Section 1244 stock defined
(1) In general For purposes of this section, the term "section 1244 stock" means stock in a domestic corporation if-
(A) at the time such stock is issued, such corporation was a small business corporation,
(B) such stock was issued by such corporation for money or other property (other than stock and securities), and
(C) such corporation, during the period of its 5 most recent taxable years ending before the date the loss on such stock was sustained, derived more than 50 percent of its aggregate gross receipts from sources other than royalties, rents, dividends, interests, annuities, and sales or exchanges of stocks or securities.
(1) Wholly worthless debts There shall be allowed as a deduction any debt which becomes worthless within the taxable year.
(2) Partially worthless debts When satisfied that a debt is recoverable only in part, the Secretary may allow such debt, in an amount not in excess of the part charged off within the taxable year, as a deduction.
§ 165. Losses
(g) Worthless securities
(1) General rule If any security which is a capital asset becomes worthless during the taxable year, the loss resulting therefrom shall, for purposes of this subtitle, be treated as a loss from the sale or exchange, on the last day of the taxable year, of a capital asset.
One interesting aspect of your case is your ability to request a late refund as need be:
§ 6511. Limitations on credit or refund
(d) Special rules applicable to income taxes
(1) Seven-year period of limitation with respect to bad debts and worthless securities If the claim for credit or refund relates to an overpayment of tax imposed by subtitle A on account of-
(A) The deductibility by the taxpayer, under section 166 or section 832(c), of a debt as a debt which became worthless, or, under section 165(g), of a loss from worthlessness of a security, or
(B) The effect that the deductibility of a debt or loss described in subparagraph (A) has on the application to the taxpayer of a carryover,
in lieu of the 3-year period of limitation prescribed in subsection (a), the period shall be 7 years from the date prescribed by law for filing the return for the year with respect to which the claim is made...
I hope all of this was helpful. Let me know if there is something I can clarify further.
Thank you for your question.
D. Discussion of IRS Revenue Ruling In, Rev. Rul. 93-80, 1993-2 C.B. 239, the IRS took the position that a taxpayer can abandon a partnership interest if the taxpayer:
i. Provides to the partnership written notification of its intent to abandon the partnership interest,
ii. Does not receive any cash or assets from the partnership,
iii. Is not relieved of any of the partnership's liabilities (including liability shifts in anticipation of the abandonment) and
iv. Does not receive even a de minimis actual or deemed distribution.
Rev. Rul. 93-80, supra, makes clear that if the abandoning partner receives any money or property from the partnership, it will be treated as a sale or exchange of the partnership interest. In that event, the resulting gain or loss will generally be characterized as capital 15 . Because a decrease in a partner's share of liabilities is a deemed distribution of money to the partner 16 , such a decrease would defeat the "abandonment" of the partnership interest.
E. Application of Abandonment Requirements In order for a taxpayer to achieve an effective abandonment, it will have to take all steps necessary under state law to effect a proper abandonment:
1. Written Notification. The taxpayer should deliver to the partnership or LLC a written notification indicating the taxpayer's voluntary withdrawal from the entity, and its effective date. The written notification should refer to the relevant partnership/LLC statutory withdrawal provisions and the section of the partnership/LLC operating agreement that permits a voluntary withdrawal. This written notification should also waive any and all rights and claims that the taxpayer has against the entity as to its interest.
2. Amendment to Partnership Agreement. Immediately after the taxpayer's withdrawal from the entity, the partnership/LLC agreement should be amended to indicate that the taxpayer is no longer a partner/member.
I've seen your question and will consider, then update again (tonight likely). Fyi.
If you do abandon the partnership, then what about your partner? Are you both abandoning simultaneously? A final partnership return will have to be filed... to whom does the distribution go, and if you distribute everything first, then how are you going to say that you "abandoned" it (in this case distribute everything and then abandon the personal investments outside of the partnership I would think, as you won't be able to say you abandoned the partnership interest should both of you wish to jump ship simultaneously, while also somehow extending/filing tax returns etc.).
You also face issues on proving the date of the abandonment, just as you did/do with the worthless securities and bad debt, though potentially tougher for an IRS agent here I'll agree... Rhetorically, has anything been sent to the state yet, for example, by you or your partner, depending on who quits and when? Any message to your partner from you that you may have saved, dated appropriately of course?
If the nature of your transaction lacks substance and avoids tax, then you're going to again have some risk... you can't exactly "abandon" an already worthless security or a debt that has already gone bad in an effort to end up with an ordinary loss. Very slick idea and a tax loophole I will agree. It is legal: IRC 165 states, "Losses from sales or exchanges of capital assets shall be allowed only to the extent allowed in sections 1211 and 1212." An abandonment is not a sale or exchange, so even though a capital asset, the loss is still ordinary.
Any chance for NOL treatment if a theft? Per IRC 172(d)(4)(C), any deduction for casualty or theft losses allowable under section 165(c)(2) or (3) as a business deduction (namely, investment losses and casualty/theft losses not related to a business), may be deducted via an NOL and carried back under the ARRA provisions up to 5 years. See Rev Rulings 2009-9 and 2009-20.
Personally and again, conservatively here, I believe you will have timing issues when it comes to abandoning or writing off the worthless debt and securities during 2009. Given what you've stated about your personal circumstances, theft or casualty might apply and thus the NOL.
Thank you again. Good luck too.
Sorry, I have been gone for 5 days.
Okay, being one who likes loopholes. No tax returns have yet been filed for 2009. My idea was that that we abandon together and dissolve the partnership in 2009. The stock could be forfeited and the debt cancelled.
The remaining cash balance would not quite cover the cost of the final return, leaving no cash to distribute (although there is a small cash balance at 12/31/09). Nothing would be distributed.
Does that work or should I just go for the 1244 stock loss as ordinary and the debt cancellation as capital? I'm running out of time, unfortunately and cannot get the company to return emails or calls. Sales and customer service numbers are out of service. The office is still there, unmanned, but with computers turned on and the President was seen there this week...I personally know the president but he is not returning calls or emails.
Do I still need to issue cancellation of debt forms?
You issue cancellation of debt forms if you cancel (not abandon) the debt. That will trigger a short term capital loss for bad debt per above.
I would not look to abandon the worthless debt and securities for the 2009 tax year if you didn't actually abandon during 2009. I think you would fail if challenged in an IRS audit. The same goes for declaring them worthless/bad, per above.
Assuming the amounts are not yet worthless, you could abandon now in 2010. That might very well be my recommendation. File away for 2009.
My ultimate suggestion was to do the NOL if this is a theft loss. I cannot say whether or not this is a theft loss over JustAnswers, therefore, you should see a local professional. Again, in this case, you may very well have to originate the NOL in 2010 too, just as per above.
I'm sorry there is no easy answer. If I just come out and say "do this," over JustAnswers, then I would not be acting responsibly. That would not be in our interest. What I can say is that you are armed with an understanding and an arsenal of solid possibilities to potentially take to a personal tax preparer. That will make things go much better for you (your CPA/EA/etc. might be impressed you've gotten this far with your options, so tell him/her you want the numbers crunched and a personal written opinion with respect to timing, theft, etc., and that you expect it done right!!... of course).
Thank you again.