This Legal Update concludes our three-part series on preferred equity in private capital markets, exploring key tax considerations for preferred equity investments. For background on preferred equity’s core features, structural implementation, and use cases, see Part 1 of this series: Preferred Equity: Another Option in the Private Capital Liquidity Toolkit. For how preferred equity compares to senior debt, mezzanine debt, and common equity legal risks, see Part 2 of this series: Preferred Equity: Comparing Alternatives and Managing Legal Risks.

Executive Summary

Preferred equity investments involve important US federal income tax considerations. As discussed in the prior installments in this series, preferred equity occupies a hybrid space between debt and equity—offering contractual priority over common equity while remaining subordinated to debt. This positioning, combined with the instrument’s economic features, makes careful tax structuring essential. Unlike interest expense in debt financing, preferred distributions are generally not tax deductible for the issuer (but interest expense deductions may themselves be limited under Internal Revenue Code Section 163(j)). Preferred equity can be especially attractive when a corporate issuer has net operating losses or otherwise gains little from interest deductions.

Preferred equity can take the form of corporate stock or partnership/LLC interests—each with distinct tax implications. For corporate preferred stock,¹ key issues include dividend taxation, potential tax benefits for corporate and noncorporate investors, and the treatment of actual or deemed stock distributions. Partnership or LLC preferred interests are typically passthrough investments, with taxable income and losses flowing directly to investors. Understanding these distinctions is critical for structuring transactions that deliver intended economic benefits while minimizing potential surprises for both issuers and investors.

Characteristics of Preferred Equity from a Tax Perspective

The prior installments in this series examined preferred equity’s position in the capital structure and its core legal features. From a US federal income tax...