Here's What Happens to Your Stock When a Company Declares Bankruptcy

When companies run into financial difficulties, they can seek out protection via the bankruptcy process, the same way individuals can file for bankruptcy when their debts spiral out of control. Filing for bankruptcy does not automatically mean a company is winding down operations and ceasing to exist. In some situations, that is the case, but often, a bankruptcy filing involves reorganizing a company's debts to allow business operations to continue.

But no matter what type of bankruptcy a given company files for, it can be bad news for investors who own shares of its stock. So if you have stocks in your brokerage account whose companies seem to be in trouble, you may want to unload them before those businesses file for bankruptcy.

Your stocks could become worthless

When a company files for bankruptcy, its stock gets delisted. At that point, it will only trade privately in what's known as the over-the-counter market. And any dividends that would normally be paid out to shareholders will cease.

Generally, when you add shares of stock to your brokerage account or IRA, you're buying common stock. But you should know that once a company files for bankruptcy, a trustee is appointed to make sure its assets are distributed as equitably as possible to creditors. And you should also know that as a holder of common stocks, you're basically last in line to get paid. Bondholders and investors with preferred stock will get paid before you do.

Does this mean that if a company files for bankruptcy, you'll get nothing from your shares? Not necessarily. But they may end up only being worth pennies on the dollar. And much will depend on how the bankruptcy itself shakes out.

If a company files for Chapter 7 bankruptcy, it means it's liquidating its assets and shutting down operations. In a situation like this, your chances of getting paid anything for your shares of stock are pretty slim.

But if a company files for Chapter 11 bankruptcy, it means it's reorganizing its debt with the intent to keep operating and move forward with a cleaner financial slate. In a Chapter 11, it's possible for new shares of stock to be issued to stockholders, so in a situation like that, you may not end up losing much or even any money.

Keep tabs on your investments

Generally speaking, if you own shares of a company that you think may be on the verge of bankruptcy, you're better off getting out and selling your stock before that filing becomes official. You might end up taking a loss on those shares, but it'll be a smaller loss than what you'd be looking at after a bankruptcy filing.

Along these lines, it's important to keep tabs on the companies you have money invested in. Once you start to see signs of financial decline, it should serve as a wake-up call to consider cashing out your shares before their value falls even more, or before a bankruptcy filing renders your shares worthless.

The good news is that losses you take in your investment portfolio can be used to offset gains. So if you have reason to believe a company you're invested in is about to file for bankruptcy and you sell your shares while they're worth a little bit of money, you might lose, say, $2,000 in the process. But if you have a $2,000 gain in your account, your loss will cancel it out. And if you don't have any gains, you can use your loss to offset some of your ordinary income.

Taking losses in your portfolio may not be ideal. But at least there's a silver lining from a tax perspective.