When your equity loses value: the tax side of a drop or a wipeout

The real danger: tax on value you never kept

The cruelest tax outcomes in equity comp do not come from a company failing. They come from being taxed at a high value and then watching the stock fall. The tax was already triggered at the peak, and a later drop does not undo it.

It shows up two ways. With NSOs or RSUs, you are taxed as ordinary income at the value when you exercise or when the shares vest. If the stock then falls, that later decline is only a capital loss, which (as below) you can use against just $3,000 of other income a year. So you can owe ordinary tax on a big number and be left with a loss you can barely use.

With ISOs, the trap is the alternative minimum tax. Exercising and holding creates AMT on the bargain element. If the stock craters in a later year, that AMT still stands. There is one important escape: if the drop happens in the same calendar year as the exercise, selling that year is a disqualifying disposition that removes the AMT preference, so you are taxed on the actual (smaller) result instead. The practical lesson across all of these is that selling enough at the taxable event to cover the tax is what protects you from being taxed on value that later evaporates.

When the stock becomes worthless

If the company actually fails, the tax code lets you deduct the loss, but the timing rule is strict. A security gives you a deduction only in the year it becomes completely worthless, not when it is merely down or nearly gone. A share trading for a penny, or a company limping along with a few assets, does not qualify. You generally need a clear, identifiable event that wipes out the equity: a formal liquidation that pays shareholders nothing, a bankruptcy plan that cancels the old stock, or the business ceasing operations and dissolving.

When it qualifies, the loss is treated as a capital loss realized on the last day of that tax year, which can push it into long-term treatment. Two practical points: you have to claim it in the correct year, which means keeping evidence of what happened and when, and the window to amend a return for a worthless security is unusually long, so a loss you discover late is not necessarily gone for good. Pinning down the year of worthlessness is genuinely hard, and it is worth getting help to support it.

Section 1244: when a loss can be ordinary instead of capital

This is the provision worth knowing if you held founder or early-employee shares in a company that failed. Normally a loss on stock is a capital loss. Section 1244 lets you treat the loss on qualifying small business stock as an ordinary loss instead, up to $50,000 a year ($100,000 on a joint return). Ordinary losses offset wages and other income directly, so the difference from a capital loss capped at $3,000 a year is enormous.

Founders and early employees with directly issued startup shares are often exactly the people Section 1244 was designed for, yet it is easy to default to a small capital loss and miss it. If a company you held original shares in has failed, it is worth checking eligibility before you write the loss off.

Capital losses, the $3,000 limit, and a few traps

When a loss is a capital loss, it first offsets your capital gains. Beyond that, only $3,000 of net capital loss can offset ordinary income in a year, and the rest carries forward indefinitely to future years. That carryforward is valuable, especially if you expect future gains (a later liquidity event, for example) to absorb it, but it does mean a large loss can take many years to fully use.

Watch the wash-sale rule. If you sell a stock at a loss and buy substantially identical stock within 30 days before or after the sale, the loss is disallowed and added to the basis of the new shares instead. This is easy to trip without meaning to, for instance by selling shares to harvest a loss while an ESPP purchase or an RSU vesting quietly buys you back in.

Two related cases come up often. An underwater option (one whose strike price is above the current value) is usually just left to expire unexercised, and an expired compensatory option generally gives no deduction, since you had nothing invested in it. And forfeiting unvested equity when you leave usually has no tax effect, because you were never taxed on it, with one exception worth remembering: if you made an 83(b) election and then forfeit the stock, you generally cannot deduct a loss for the income you previously reported.

Equity loss questions people ask

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