Best Taxation of Convertible Preferred Dividends

Best Taxation of Convertible Preferred Dividends : There are two basic types of preferred stock you can issue: hybrid or traditional. The type of preferred stock you issue will have an impact on your tax treatment, and consequently on the tax that investors pay on the dividends they receive. Some preferred stock has a convertible attribute, which does not have an impact on taxes unless an investor chooses to convert his hybrid preferred stock to common shares.



Hybrid Preferred Stock

Hybrid preferred stock is part debt and part equity. It represents a debt obligation to the company, while providing stockholders with a percentage of equity ownership in the company. When you pay dividends on hybrid stock, you use pretax dollars, which reduces your taxable corporate income. If you own hybrid shares, your dividends will be taxed in the same way as bond interest, which is taxed as normal income.



Traditional Preferred Stock

Unlike hybrid preferred stock, traditional preferred stock does not mature, but the company can call it back, meaning that the company can buy it from stockholders at a fixed price. If you issue traditional preferred stock, dividends you pay come from after tax dollars, or from earnings after tax has already been paid. If you own traditional preferred stock, your dividends are taxed as dividend earnings, which are taxed at 15 percent or less, depending on your tax bracket.



Convertable Preferred Stock

Preferred stock, whether hybrid or traditional, can contain one or more attributes. One of these attributes is convertibility. If you issue preferred shares that are convertible, you give investors the right to convert shares into common stock. Most convertible stock can be converted after a set date at a specific share price. If you own convertible hybrid stock, you may be able to reduce your taxes by converting it into common stock, because common dividends are taxed at a lower rate for most people.



Required Holding Period

If you earn dividends on hybrid preferred stock, your dividends will be taxed at your normal tax rate. If you own traditional preferred stock, your dividends will be taxed at the reduced dividend tax rate, as long as you meet the holding requirements. In order to qualify for the lower dividend tax rate, you must hold your stock for at least 90 days after receiving a dividend. (source smallbusiness.chron.com )