Question

Blue Corporation has 100 shares of common stock issued, of which 50 shares are owned by Carmine Blue, and 50 shares are owned by his wife, Violet Blue. Blue Corporation distributes to each of them 50 shares of a newly-created issue of preferred stock. The preferred shares distributed have an aggregate value of $100,000, and the remaining value of the corporation (that is, the aggregate value of the common stock outstanding) is $100,000. The newly-issued preferred shares are convertible, and any number of shares of preferred stock may be converted into an equal number of shares of common stock, without limit, at any time, at the option of the preferred shareholder.

Describe the tax issues raised by the issuance of the preferred stock, as well as the future sale or redemption of the preferred stock?

Answer 1

On issuing preferred stock the companies have to pay dividend to these shareholders, the dividend payment made by the company to preference shareholders is not tax deductible, unlike where companies pay interest on debt they can tax deductibility on interest. As dividend is paid from earnings available after tax, hence there is no tax deductible on dividend. On sale of preferred stock one will have to pay capital gains tax on it if the sale price of the stock is more than the purchase price of the stock. On redemption of shares by the company the individual will have to pay tax on deemed dividend and also capital gains on the redemption.