IRS rules on auction-rate preferred stock.

Corporate

IRS RULES ON AUCTION-RATE PREFERRED STOCK 

Internal Revenue Service revenue ruling 90-27 resolves the questions of whether auction-rate preferred stock is debt or equity and whether a corporate holder of the stock is entitled to a dividends-received deduction.

The ruling concludes equity treatment is proper--even though investors view aution-rate preferred stock as an alternative to commercial paper or other short-term debt. Equity was found because a holder's rights are similar to those with traditional preferred stock. A holder has no right to receive a certain sum on demand or on a specified date; a holder's rights on liquidation or in bankruptcy are subordinate to claims of creditors; and receipt of dividends depends on their being declared and paid out of legally available funds.

The availability of the dividends-received deduction depends on achieving at least a 46-day holding period for the underlying stock. The problem is the holding period credit is not earned for days on which the holder is insulated from market risk or possesses an option (or equivalent rights) to sell the stock.

The ruling concludes that the expectation of being able to sell stock in any auction does not rise to the level of a guarantee of salability, because an auction may fail. Hence, no formal option to sell exists. Moreover, no de facto option to sell is present. The broker-dealer does not guarantee the success of each auction and, although the penalty rate paid in the event of a failure gives the issuer an incentive to redeem the stock, the rate is not sufficiently high to compel a redemption.

Observation: Ironically, the possibility of a failed auction--an event that has actually occurred on numerous occasions--provides the element of risk that allows a holder of auction-rate preferred stock to satisfy the 46-day standard for earning a dividends-received deduction.