2026年3月30日

Preferred Equity: Key Tax Considerations

作者:

This Legal Update concludes our three-part series on preferred equity in private capital markets, exploring key tax considerations for preferred equity investments. For background on preferred equity’s core features, structural implementation, and use cases, see Part 1 of this series: Preferred Equity: Another Option in the Private Capital Liquidity Toolkit. For how preferred equity compares to senior debt, mezzanine debt, and common equity legal risks, see Part 2 of this series: Preferred Equity: Comparing Alternatives and Managing Legal Risks.

Executive Summary

Preferred equity investments involve important US federal income tax considerations. As discussed in the prior installments in this series, preferred equity occupies a hybrid space between debt and equity—offering contractual priority over common equity while remaining subordinated to debt. This positioning, combined with the instrument’s economic features, makes careful tax structuring essential. Unlike interest expense in debt financing, preferred distributions are generally not tax deductible for the issuer (but interest expense deductions may themselves be limited under Internal Revenue Code Section 163(j)). Preferred equity can be especially attractive when a corporate issuer has net operating losses or otherwise gains little from interest deductions.

Preferred equity can take the form of corporate stock or partnership/LLC interests—each with distinct tax implications. For corporate preferred stock,¹ key issues include dividend taxation, potential tax benefits for corporate and noncorporate investors, and the treatment of actual or deemed stock distributions. Partnership or LLC preferred interests are typically passthrough investments, with taxable income and losses flowing directly to investors. Understanding these distinctions is critical for structuring transactions that deliver intended economic benefits while minimizing potential surprises for both issuers and investors.

Characteristics of Preferred Equity from a Tax Perspective

The prior installments in this series examined preferred equity’s position in the capital structure and its core legal features. From a US federal income tax perspective, preferred equity is typically structured to reflect those same equity characteristics—aligning commercial, legal, and tax treatment as an equity investment rather than a creditor relationship.
Common characteristics of preferred equity from a tax perspective include the following:

Equity-Based Returns: Preferred equity generally provides a fixed or formula-based return tied to the issuer’s profits, available cash, or other equity-based measures rather than a fixed interest-like payment obligation.
No Fixed Maturity or Repayment Obligation: Not all preferred equity includes a binding obligation to repay invested capital on a fixed schedule or at a stated maturity date. In many cases, capital is returned through equity events such as redemptions, distributions, or liquidity transactions.
Equity Position in Capital Structure: Preferred equity generally ranks ahead of common equity for distributions and liquidation proceeds, but is subordinated to all debt obligations.
Limited Creditor Rights: Preferred equity holders generally lack customary creditor remedies.
Voting and Control Rights: While not universal, voting or management participation is more indicative of equity; lack of control (absent default) is more consistent with debt.

Whether an instrument is treated as debt or equity for US federal income tax purposes depends on its terms and the overall investor-issuer relationship, which may differ from the parties’ labels or from corporate law or accounting classifications. These equity-oriented features help distinguish preferred equity from indebtedness and inform the tax considerations below.

Deductibility Considerations

The choice between debt and preferred equity has significant tax implications. Interest on debt is generally deductible, but deductions may be limited under Section 163(j) or other Internal Revenue Code provisions. (Section 163(j) may not apply if the borrower earns sufficient interest income or taxable income to exceed the limitations.) Preferred equity, by contrast, offers a fixed or cumulative return but dividends are not deductible for the issuer.² This avoids Section 163(j) complexity, but provides no deductions against the borrower’s taxable income. Preferred equity may also appeal to corporations with existing tax losses that gain little from additional interest deductions. The decision often comes down to balancing the issuer’s desire for deductible payments against the investor’s preference for a stable, contractually defined return.

Investments in Preferred Stock and Partnership Interests

Preferred Stock Investment in a US Corporation

Key US federal income tax considerations relevant to an equity investment in preferred stock include the following:

Taxation of Dividends: Corporations are subject to entity-level taxation, and shareholders are generally taxed only when distributions are made. As such, holding preferred stock has limited US federal income tax consequences until the issuing corporation declares and pays distributions. Once dividends are declared and paid, shareholders are typically subject to tax on the dividend, although the effective rate depends on whether the distribution is a “qualified dividend” (for non-corporate recipients) or eligible for a dividends received deduction (for corporate recipients), as discussed below. A common feature of preferred stock is that dividends often accrue and accumulate over time and are not immediately payable, in some cases until a liquidation event or another time when the issuer is able to distribute cash. Structured carefully, unless a formal dividend is declared, or the preferred holder has the right to receive or accelerate payment, accrued but unpaid dividends may not be taxable until declared and paid—unlike paid-in-kind (PIK) loans, where holders must generally pay tax on original issue discount accrual regardless of whether they receive interest payments.

Dividends Received Deduction (DRD): Corporate holders of preferred stock may be eligible for the DRD, which allows deduction of a portion of dividends received from other US corporations. This provides a meaningful advantage over interest income, which is fully taxable. The deduction percentage generally depends on the ownership level in the issuing corporation and can significantly reduce the effective tax rate on dividend income, making preferred stock attractive for corporate investors.³

Qualified Dividend Income: Dividends on preferred stock may qualify as Qualified Dividend Income (“QDI”), allowing noncorporate investors to benefit from preferential long-term capital gains rates rather than the ordinary income rates applicable to interest income.⁴ Eligibility requires satisfying certain holding period requirements, and dividends generally must be paid by a US corporation or qualified foreign corporation. This preferential treatment makes preferred stock attractive compared with debt instruments, which produce interest income fully taxable as ordinary income.

Stock Dividends: Section 305 governs the tax treatment of stock dividends. While stock dividends are often tax-free, Section 305 creates taxable exceptions when a distribution affects relative ownership, offers a choice of cash or property, or meaningfully alters stockholder rights. The statute prevents shareholders from receiving value in disguised form without recognizing income—particularly relevant in complex equity structures with multiple stock classes.

Section 305 is especially relevant when a distribution or adjustment changes the holder’s economic or voting position relative to other shareholders. Common triggers for current taxation—even without cash receipt—include issuing additional preferred shares to existing preferred holders (including PIK dividends), modifying liquidation preferences, and adjusting conversion ratios. These rules require careful analysis whenever preferred stock distributions or rights adjustments are made. Critically, these deemed dividend rules depend on whether the stock is “preferred” or “common” for tax purposes—a determination that may differ from commercial labels. Accordingly, preferred stock with meaningful participation rights (such as participation in dividends or liquidation proceeds beyond stated preferences) may avoid these deemed dividend rules.

Even if preferred stock is treated as “common stock” for Section 305 purposes, PIK dividends or deemed value increases can become taxable if they are part of a “disproportionate distribution.” A disproportionate distribution occurs when the distribution (or deemed distribution) has the result of the receipt of cash or property by some shareholders and an increase in the proportionate interest of other shareholders. Common triggering events include cash dividends paid on other stock classes while PIK dividends accrue on preferred, interest payments on convertible debt while PIK dividends accrue, and redemptions of stock from other shareholders.

Exit Taxation: A significant advantage of preferred stock over debt is the potential for favorable exit treatment. If dividends accrued but were never formally declared or paid, the portion of the redemption price attributable to those dividends may, under certain circumstances, be treated as capital gain rather than ordinary dividend income. This contrasts with debt instruments, where accrued but unpaid interest is always taxable as ordinary income. For investors seeking capital gain treatment, preferred stock with accumulating dividends can offer significant tax advantages.

Non-US Investor Considerations: Non-US investors must carefully consider withholding tax implications. Dividends paid to non-US persons are generally subject to 30% withholding (or a reduced rate under an applicable income tax treaty). This withholding applies to both cash dividends and deemed dividends under Section 305—creating potential cash-flow mismatches where the issuer must remit withholding tax without an actual distribution to withhold from.

Preferred Interest Investment in a US Partnership or LLC

Investing in preferred interests or units of an LLC or partnership presents different tax considerations than preferred stock. Many preferred investments are made in LLCs taxed as partnerships, ensuring no member assumes general partner liability. (References to “partnership” or “partner” in this Legal Update include LLCs taxable as partnerships and their members.) Key US federal income tax considerations relevant to investments in preferred interests include the following:

Passthrough Taxation: Unlike corporations, partnerships are not subject to federal income tax at the entity level. Income and losses flow through to partners, who report these amounts on their respective tax returns—resulting in a single level of US federal taxation at each partner’s applicable rate. Partners can generally use allocated losses to offset other income (subject to applicable limitations) and increase their tax basis in their partnership interests as income is allocated. This contrasts with corporate stock, where basis does not increase with corporate-level earnings.

Phantom Income and Guaranteed Payments: As a result of a partnership’s passthrough treatment for US federal income tax purposes, holders of preferred interests are generally taxed on their allocable share of partnership income—even without distributions. This can result in “phantom income” where investors must pay taxes on allocated amounts (typically the preferred return) whether or not they receive distributions.

Partnership distributions can also give rise to guaranteed payments, taxable to the partners as ordinary income, even in loss years. A guaranteed payment is made to a partner without regard to partnership income—it is not contingent on profits and is payable even if the partnership experiences a loss. If the preferred return is paid regardless of partnership income, it may be classified as a guaranteed payment. Guaranteed payments are taxable to the recipient as ordinary income, regardless of the partnership’s underlying income character. For example, if a partnership earns long-term capital gain, a preferred return structured as a guaranteed payment is still taxable to the preferred holder as ordinary income.
To address phantom income issues, partnerships typically make quarterly or annual tax distributions sufficient to cover investors’ tax liabilities. Tax distributions address tax obligations only and generally do not alter the economic arrangement. They are often treated as advances against future payments rather than additional distributions.

Unrelated Business Taxable Income: For US tax-exempt investors, holding a preferred partnership or LLC interest can generate Unrelated Business Taxable Income (UBTI)—even if distributions are economically passive. UBTI may arise if the partnership conducts an active trade or business, or if the interest is acquired with debt financing, as the income could then be treated as debt-financed UBTI under Section 514. Proper structuring, including the potential use of blocker corporations, can help mitigate UBTI exposure.

Effectively Connected Taxable Income: For non-US investors, holding preferred partnership interests can create Effectively Connected Taxable Income (ECTI) if the partnership conducts a US trade or business. The investor is generally treated as directly earning its share of the partnership’s income and may need to file a US income tax return. Partnerships must withhold tax on non-US partners’ allocable ECTI shares, even without distributions. To reduce direct US income tax exposure and filing obligations, non-US investors often invest through US blocker corporations that shield them from direct ECTI recognition.

For more on preferred equity transactions, see the prior installments in this series:

¹ An S corporation cannot issue preferred stock because it can only have one class of stock. Although differences in voting rights are permitted, differences in distribution or liquidation rights create a second class of stock and would terminate or preclude S corporation status.

² For entities treated as partnerships for US federal income tax purposes, payments on preferred interests that are structured as guaranteed payments are generally deductible by the partnership under Section 707(c), subject to applicable limitations.

³ The percentage of the deduction depends on the shareholder’s ownership level in the issuing corporation, which is generally 50% for less than 20% ownership (effective tax rate of 10.5%), 65% for ownership between 20% and 79% (effective tax rate of 7.35%), and 100% for 80% or more ownership. Certain limitations apply under Section 246(c), including rules for preferred stock that are specially allocated or carry contingent dividends.

⁴ The applicable preferential rates are currently 0%, 15%, or 20%, depending on the investor’s taxable income.