What happens if you invest in a company and the company fails? Can you deduct your loss? If you can deduct your loss, what sort of loss is it, capital or ordinary?
An ordinary loss is the best type of loss because it can be set off against ordinary income (your salary). Capital losses are only deductible against capital gains plus $3K of ordinary income per year. If you don’t have much in the way of capital gain, because of this $3K per year limitation, it might take you years to fully deduct your losses.
In general, investments in corporations result in capital losses only when the corporation’s stock is completely worthless. The “completely worthless” test can require that the company be completely dissolved and wound up*. Even if the corporation is nearly dead, it still may not be dead enough for you to take a loss. One way to take the loss on a nearly defunct company is to assign the shares for $1 to an unrelated third party. Some angel groups set up programs to facilitate these types of assignments.
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