Deconstructing Constructive Dividends

A closer look at the tax treatment of discount preferred stock could help companies avoid "phantom" income associated with constructive dividends.
Robert WillensMay 15, 2002

When preferred stock is issued for a price less than its redemption price, the difference—or the discount—may be treated as a constructive dividend. Accordingly, the discount will have to be taken into account when computing the holder’s taxable income over the term of the instrument. Important to note, however, is that not all stock which has preferences, vis à vis the common stock, is regarded as preferred stock.

For tax purposes, the key is whether those preferences are limited. Therefore, consider this: Stock is not preferred stock—despite the existence of preferences—if the stock has a “real and meaningful” probability of actually participating in corporate earnings and growth. If these rights to participate are “significant,” the stock will not be regarded as preferred stock and, hence, there will be no constructive dividend income flowing from such stock even if it is issued at a discount. (See Revenue Ruling 81-91.)

However, in assessing whether an instrument has a real and meaningful probability of participating in earnings and growth, any right to convert the security into common stock is disregarded. In other words, the security must have growth on its own account, and the growth potential inherent in a conversion feature, is, curiously, ignored. It’s ironic, therefore, that such a conversion feature is taken into account to determine—within the meaning of Sec 531(g) —whether stock is, for purposes of Part III of Subchapter C, “non-qualified preferred stock.”

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Unfortunately, Sec 305 is located in Part I of Subchapter C (a conversion feature), and therefore cannot remove stock from preferred classification if such a stock does not participate in corporate growth to any significant extent.

Where preferred stock is mandatorily redeemable at a specified time, or where the holder of the security has a right to “put” it to the issuer (or related party), the discount at which the stock was issued must be amortized into a holder’s income (as dividend income under Sec 305(b)(4)), unless it is de minimis. The discount is only considered de minimis if it is less than .0025% times the redemption price of the security times the number of complete years from issuance to the redemption date.

If the discount does not fall within this de minimis exception, the entire amount of discount (not just the portion that exceeds the de minimis amount) must be amortized into a holder’s income on a “economic accrual” basis.

The regulators further provide that preferred stock is mandatorily redeemable, for purposes of the amortization rule, even if the redemption obligation is subject to a contingency, unless that contingency is 1) beyond the control of the holder; and 2) renders “remote” the likelihood of redemption. In short, accrual of the discount will be required in these cases unless the likelihood that the precipitating event is not merely problematical but, instead remote.

In addition, the regulations treat merely callable preferred stock in the same manner as manditorily redeemable (and puttable) preferred stock is treated regarding the necessity of amortizing the discount. However, that’s only true if, as of the date of issuance, a redemption pursuant to the call right, is “more likely than not” to occur.

Fortunately, in the case of callable preferred stock, a regulatory “safe harbor” exists—which, if met, means that a redemption, pursuant to the call right, is more likely than not to occur. The safe harbor is considered met if, 1) the issuer and holder of the security are not “related”; 2) there are no arrangements that “effectively require” or are “intended to compel” the issuer to redeem the security (for example, if the issuer does not redeem the security, the holders of the callable preferred stock can elect a majority of the members of the issuer’s board of directors.); and 3) the exercise of the call option would not reduce the instrument’s yield—such a call would reduce yield if the preferred stock featured an escalating yield or redemption price.

Moreover, the Internal Revenue Service has the right—although it has not exercised it yet— to provide that a “disguised discount,” subject to the rules depicted above, exists in certain cases. For example, when cumulative preferred stock is issued without a discount, but there is, at the time of issuance, no intent on the part of the issuer to pay dividends currently.

In any event, for the holder, these rules can create something that is normally to be avoided: “phantom” income (taxable income unaccompanied by cash with which to defray the tax liability assessed on such income).

However, for a corporate investor, discount preferred stock may prove to be quite attractive. It allows a corporate holder to build up its basis in the security at a tax rate that is reduced by the intercorporate DRD (dividends-received deduction), under which a corporate recipient of a dividend enjoys a 70 percent deduction, rather than report fully taxed capital gains upon the redemption of the security.

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