Yield-hungry investors who purchased so-called preferred stocks in recent years may be disappointed to find that their "dividends" won't qualify for the new lower federal tax rates.
The tax-reform law passed by Congress last week will cut the maximum tax rate on dividend income to 15% from 38.6%.
But the lower rates apply to true dividends, such as on common stocks. By contrast, most companies that have issued preferred stocks in recent years have structured those securities to pay interest rather than dividends -- even though investors often have continued to think of the payments as dividends.
Interest earnings will continue to be taxed at ordinary rates, as high as 35%.
Preferred stock has long been used by U.S. companies to raise capital. The shares typically don't carry voting rights, but pay a fixed return that often has been comparable to or better than what investors could earn on bonds.
Richard Lehmann, a Miami-based investor who publishes newsletters for income-oriented investors, said the universe of outstanding preferred stock totals more than $400 billion. About 95% of the securities are "trust preferreds" -- the income payments of which are considered interest rather than dividends, Lehmann said.
That structure, widely adopted by companies in the 1990s, allowed firms issuing preferred stock to write off the payments they made, Lehmann said. "They wanted to get the tax deduction," he said.
Because of the new tax law, many companies may try to refinance outstanding trust preferred securities, issuing new stock that pays true dividends, Lehmann said. "The change creates a definite incentive for companies to issue straight preferred stock," he said.