Capital Loss on Unrecoverable Debt

I was gifted $500,000 worth of the stock in a privately held company in 2018. The stock was immediately bought back from me by issuing me a $500,000 promissory note to be paid in ten equal $50,000 payments starting Dec 31, 2022. Not sure it matters but all legacy shares, mine included, were bought back by the company so that these shares could be retired and new shares issued as part of the creation of an ESOP.

Roll the clock forward to present and the company is probably going to run out of cash and have to cease operations in the next six months. We have plenty of purchase orders from long term customers but we cannot complete these orders because we cannot get product from our suppliers due to supply chain issues. We have been in a state of steady decline for about a year for this reason and there doesn’t appear to be any way to avoid the inevitable.

So the question is, if the company cannot pay its debt to me (and others), how is that treated on my taxes. I have read that this should be reported as a short term capital loss with a tax basis of zero. But I can’t seem to find if I report the entire $500,000 in year 1 or just the $50,000 per year based on the payment schedule for the note. Any advice or perspective or other angles to this would be most appreciated. The silver lining if there is one, with capital loss carry forward, I will never have to pay cap gains tax again.

Did you declare any income on your taxes when you received the stock or the note, or was there any income denoted on a W-2? If not, I’m finding it hard to understand how you can declare a loss on the note, when you never declared any income from the stock. Generally, you don’t get any income from stock grants until they are actually vested, at which point you have to pay taxes on the value of the stock. Since your stock was immediately traded for a promissory note, apparently it was vested when it was granted, so you would have had to declare income at some point. There were some changes to the law to ease the illiquidity issue for private company stock in the TCJA, but those changes still only gave, at most, 5 years to recognize the income, which means you would have to recognize the income in 2023 at the latest. Here’s an article about those changes IRS Guidance On Private Company Grants Of Stock Options And RSUs Provides Limited Support (forbes.com)

But I can’t seem to find if I report the entire $500,000 in year 1 or just the $50,000 per year based on the payment schedule for the note.

What are the specific terms of the note with respect to default? Does the entire note become due and payable if a single payment is missed? If not, then I don’t see how you could declare the entire note as a loss initially. I’m not even sure that you could declare the missed payment as a loss for 2022, since there may be some cure time allowed, which would mean that you won’t actually have a loss until the cure time is exceeded.

AJ

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I will have to read over the promissory note see what it says about default and report back.

As far declaring income when the stock was gifted is concerned, this was not a stock grant by the company. This was a privately owned company with 100% of the stock owned by the founder. When he retired he gifted the stock he owned personally to me and six others. It was explained to me this was a gift and the value of the stock at that time he would cover for any gift taxes due from his side. All I and the others would be responsible for was the interest income on the notes until the balance was paid. Since the amount given exceeded the $12,000 annual limit, assume the he deducted the excess for each of us from his lifetime exclusion.

Except there the issue of the sale of the stock. At the top of the thread, you mentioned that you were gifted the stock and then immediately sold it. With the gift, you would have taken over the giver’s basis in the stock. Then when you immediately sold the stock, you would be responsible for any capital gain on the stock at that time. So that’s the next thing that aj is going to hone in on.

If you paid tax on the gain, then you have basis in the note and can deduct your loss on the uncollectible note. But if you did not pay tax on the stock sale, you’ve got a bit of a mess.

–Peter

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The value of the stock was $500,000 at the time of the gift. This was established by an outside appraiser as part of establishing the ESOP. So I was gifted something that was valued at $500K and immediately sold it for $500K. The company did not have the $500K in cash to give me, so they essentially borrowed $500K from me and issued the promissory note and then used that $500K to pay me for stock. So I don’t see how I had any gain across that transaction.

For a gift, that is mostly irrelevant. The recipient of a gift assumes the giver’s cost basis in the gifted item. If the FMV happens to be less than the cost basis, then the FMV can become relevant. Given information in your earlier posts, I doubt that is the case here.

–Peter

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What are the specific terms of the note with respect to default? Does the entire note become due and payable if a single payment is missed? If not, then I don’t see how you could declare the entire note as a loss initially. I’m not even sure that you could declare the missed payment as a loss for 2022, since there may be some cure time allowed, which would mean that you won’t actually have a loss until the cure time is exceeded.

AJ

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AJ - The note is explicit that the entire balance becomes due and payable if a scheduled payment is missed. Here is the exact verbiage:

5.1 Event of Default. The failure of the Company to pay when due any principal,
interest, or other amounts due and payable under the Note or under this Seller Credit Agreement shall be an “Event of Default.”

5.2 Remedies. Upon the occurrence of an Event of Default, the Seller (i) may, by
notice to the Company, declare the entire principal of and accrued interest on the Note to be immediately due and payable, whereupon the Note and all accrued interest will thereupon immediately become due and payable, and (ii) the Seller may exercise any or all other remedies available under law or under any other agreements or instruments securing or related to the Note.

Well, I wouldn’t say that it immediately becomes due and payable. You seem to be missing the point that you have to give notice to the company before it becomes due and payable. My contention would be that It becomes due and payable when the seller (you) notifies the company. That’s going to take at least one more business day (since you have to wait until the end of the day on Dec 31, 2022 to be sure you won’t get the payment), which won’t be until Jan 3, 2023, unless the company declares BK before then. At that point, you would need to see what the BK court will do before the debt is declared worthless, and therefore would be a capital loss.

That said - I agree with @ptheland that you should have immediately declared a short term $500k gain (minus the giver’s basis, unless the FMV in 2018 was less than the giver’s basis) when the stock was sold and you become the holder of the $500k promissory note. Without declaring the gain, I fail to see where you actually have a loss that can be declared.

AJ

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AJ - thank you and ptheland for providing this information. Not the answer I was hoping for but now I have reliable information about my situation. Hopefully some miracle will save the company but if not I know how to proceed. Thanks again and to TMF for retaining this valuable forum.