The looming tax bill of Strategy preferreds
Michael Saylor, founder of Strategy (formerly MicroStrategy), has promoted the tax-deferred benefits of Return of Capital (ROC) dividends paid to preferred shareholders. Although these dividends delay taxation, they do not eliminate it, as the tax liability grows over time. Strategy offers high 'tax-equivalent' yields and forecasts over 10 years of maintaining ROC status, which requires strict avoidance of positive taxable earnings. ROC dividends reduce shareholders' tax bases, leading to increased tax obligations once the basis is fully depleted or shares are sold. While Strategy advertises a 10% annual dividend rate on specific preferred shares, these payments result in compounding tax liabilities as the cost basis erodes year by year. Eventually, all ROC dividends and the entire Stated Amount may become fully taxable. The company's approach and risks are disclosed in its filings and quarterly earnings reports.
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Michael Saylor's Claims on Tax-Deferred Dividends
On several recent TV interviews, Strategy (formerly MicroStrategy) founder Michael Saylor has boasted about the benefits of tax-deferred dividends that it pays to preferred shareholders. Sadly, there is never a free lunch on Wall Street. These Return Of Capital (ROC) dividends are ballooning a tax debt onto preferred investors at an accelerating growth rate. Tax deferred does not mean tax free. Although Strategy’s peculiar form of ROC dividends does not impose immediate taxes, their mounting obligations increase at an ever-faster rate as future deadlines near.
Generous Yields and Prominent ROC Promotion
Strategy advertises generous, “tax equivalent” yields as high as 21.6% for its preferred dividends under the assumption that the company will maintain ROC status. Far from a minor footnote, the company has prominently featured ROC assurances in its most recent quarterly earnings report, dedicating an entire slide and several minutes of its presentation to ROC guidance.
Read more: Strategy needs to pay $689M a year to not sell bitcoin.
It forecasts more than 10 years of ROC dividend status – a formidable feat in and of itself. To achieve this, the company must carefully avoid positive taxable earnings or profits and adhere to a lengthy list of prohibited corporate actions to legally return capital rather than pay qualified disbursements to shareholders.
Legal Risks and SEC Disclosures
The company has disclosed the risks and importance of maintaining ROC status in SEC filings. For example, in a statement on July 21, it admitted:
“To the extent that the amount of a distribution with respect to the Preferred Stock exceeds our current and accumulated earnings and profits, the distribution will be treated first as a tax-free return of capital to the extent of the holder’s adjusted tax basis in the Preferred Stock.”
In other words, the company must keep its earnings and profits low enough to pay out ROC dividends.
Implications of ROC Dividends for Investors
ROC dividends delay, not reduce, tax. Even assuming Strategy can maintain ROC status for dividends, tax authorities like the IRS will eventually collect on those Return Of Capital dividends. As the saying goes, it is impossible to be certain of anything but death and taxes.
Specifically, ROC dividends reduce investors’ tax basis. Rather than receiving cash as a qualified dividend disbursement, ROC dividends simply reduce the basis at which a taxpayer calculates their cost basis when reporting their profit and loss at the time of sale.
STRD and STRF Dividends Explained
For example, Strategy intends to pay $10 worth of ROC dividends annually to every STRD and STRF shareholder, i.e., a 10% annual dividend rate on their $100 Stated Amounts. (Strategy’s two other preferred shares, STRK and STRC, pay 8% and a variable 10.5% rate, respectively.)
However, shareholders do not actually receive $10 as cash in their brokerage account per share of STRD or STRF. Instead, Strategy issues a non-taxable, Return Of Capital to shareholders of record as of dividend snapshot dates. This reduces the tax basis, leading to increased taxation for the holder once the tax basis is fully depleted or the shares are sold.
The Compounding Tax Burden Over Time
A $10 ROC dividend on a $100 stated amount represents a 10% tax basis reduction in the first year, reducing the cost basis to $90. The second year’s $10 dividend on a $90 basis leads to an 11% tax basis reduction, lowering the cost basis to $80, and so on. Each successive year becomes more tax-deferred, increasing the tax burden for the final year at an ever-higher rate.
Eventually, the tax basis of an investment could become depleted entirely, such as after ten years of $10 worth of annual basis reduction on STRD or STRF. At this point, all subsequent dividends become fully taxable regardless of Strategy’s ROC status. Furthermore, this total basis depletion could make the entire $100 Stated Amount worth of dividends immediately taxable when the shareholder sells their shares.