Accounting for Redeemable Preferred Stock

Redeemable preferred stock is a hybrid security combining features of both debt and equity, offering companies a flexible way to raise capital. It represents a class of ownership with a higher claim on a company’s assets and earnings than common stock. This instrument is defined by a future redemption, where the issuing company can buy back the shares at a later date.

Key Features of Redeemable Preferred Stock

The terms of redeemable preferred stock are outlined in the agreement between the issuer and investor. A redemption provision dictates how the company can repurchase the shares, falling into two main categories: mandatory and optional. With mandatory redemption, the company is legally obligated to redeem the shares on a specific date or event. In contrast, optional redemption, also known as callable preferred stock, gives the company the right, but not the obligation, to buy back the shares at its discretion after a certain date.

The redemption price is the amount the company must pay to redeem each share and is set at a premium to the stock’s par value. This price, along with the specific redemption date or period, is established in the initial offering documents.

Dividends on redeemable preferred stock can be cumulative or non-cumulative. If cumulative, any unpaid dividends accumulate and must be paid before any dividends are distributed to common stockholders. The dividend rate can be fixed, providing a predictable income stream, or a floating rate that adjusts with market interest rates.

Preferred stockholders have a liquidation preference over common stockholders. In the event of a company’s liquidation, holders of preferred stock are entitled to receive payment from the company’s assets before common shareholders. This preference is equal to the initial purchase price plus any declared but unpaid dividends.

Accounting and Balance Sheet Classification

Under U.S. GAAP, the accounting for redeemable preferred stock depends on whether it behaves more like debt or equity, which determines its balance sheet classification. The guiding principles are in the Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC) 480. There are three potential classifications: liability, temporary (or mezzanine) equity, or permanent equity.

Liability classification is required for preferred stock that is mandatorily redeemable. If the stock must be redeemed on a fixed date for a fixed amount, it creates an unconditional obligation for the issuer. This instrument is economically similar to debt and is presented as a liability, with dividend payments treated as interest expense.

Mezzanine equity classification is used for stock that is redeemable upon an event outside the issuer’s control, such as if the holder has the option to redeem. Because redemption is not certain but also not fully at the company’s discretion, it is presented in a separate section on the balance sheet between liabilities and permanent equity.

Permanent equity classification is appropriate only when redemption is solely at the option of the issuing company. If the company has the exclusive right to decide whether to redeem the shares, the instrument lacks the obligatory nature of a liability. In this case, the preferred stock is treated as a component of the company’s permanent equity.

Tax Implications for Issuers and Investors

The tax treatment of redeemable preferred stock differs for the issuer and the investor. For the issuing company, dividends paid on preferred stock are not tax-deductible, unlike interest payments on debt. This is because dividends are a distribution of after-tax profits, making preferred stock a more expensive form of financing from a tax perspective.

For investors, dividends received may be classified as “qualified dividends” and taxed at lower long-term capital gains rates, provided certain holding period requirements are met. Dividends that do not meet these criteria are taxed as ordinary income at the investor’s marginal tax rate.

When the stock is redeemed, the investor’s tax consequences depend on the difference between the redemption price and their tax basis in the stock. This difference is treated as a capital gain or loss.

Internal Revenue Code Section 305 addresses redemption premiums, which exist when the redemption price exceeds the issue price. If this premium is considered unreasonable, it may be treated as a “constructive dividend” and taxed as dividend income to the investor over the period the stock is outstanding.

The Redemption Process

The redemption process begins when the company issues a formal call notice to shareholders. This notice announces the decision to redeem and provides details such as the redemption date, the price, and the specific shares being called. There is a notice period, often 15 to 30 days, between the announcement and the redemption date to give shareholders time to prepare.

On the redemption date, the shareholder surrenders their stock certificates, or the process is handled electronically for shares in “book-entry” form. The shareholder then receives the redemption payment. Once the call notice is issued, dividends on the redeemed shares cease to accrue after the redemption date.