Taxable Preferred Securities

Taxable preferred securities are a type of preferred equity security. Taxable preferred securities do not qualify for the dividends-received deduction for corporations that typical preferred securities do.

Taxable preferred securities are securities that trade like bonds, in regular denominations of $25 par and $1,000 par. The $25 par securities are usually bought and sold by retail investors, whereas institutional investors primarily deal in the $1,000 par securities. Taxable preferred securities are usually junior level liabilities, and the coupons tied to them can either be fixed or variable, and for indefinite or specific maturities.

The IRS treats the dividends paid as regular income instead of dividends to the investor. Corporations receive a more favorable tax treatment for their taxable preferred securities than individuals do. Because of this, taxable preferred securities typically trade at higher yield spreads than regular preferred securities. This type of security started to take off in the mid-1990s. Since then, the popularity of taxable preferred securities continued to increase, leading to several funds and exchange-traded funds that invest solely in taxable preferred securities.

The IRS does not tax all preferred securities the same way. Many preferred dividends are qualified and taxed at a lower rate than normal income. Preferred stocks, a kind of preferred securities, are shares of a company’s stock with dividends that pay out to shareholders before common stock dividends are issued. Some refer to preferred stocks as the stock that acts like a bond. Preference shares are an optimal alternative for risk-averse equity investors. Preference shares are typically less volatile than common shares and offer investors a steadier flow of dividends. Also, preference shares are usually callable; the issuer of the shares can redeem them at any time, providing investors with more options than common shares. If these investors are unable to use the dividends-received deduction, a federal tax deduction on their securities, those securities are taxable preferred securities.

The name for taxable preferred securities stems from their failure to qualify for the dividends-received deduction, a federal tax deduction applicable to certain corporations that receive dividends from related entities. The purpose of this deduction is to alleviate the potential consequences of triple taxation. Triple taxation occurs when the same income gets taxed in the hands of the company paying the dividend, then in the hands of the company receiving the dividend, and again when the ultimate shareholder receives a dividend.