| Preferred Stock Original Issue Discount (OID) |
Some investors were shocked to receive Form 1099 reports of 2009 taxable interest income due to original issue discount on their preferred stock investments in issues such as Ford Motor Co Capital Trust II 6.50% Cumulative Convertible Trust Preferred Securities (Ford Preferred Series S.) The payment of preferred dividends had been suspended on this issue, but the shareholder was being taxed on income that had not even been received. How do you account for this?
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The Jan 24, 2002, prospectus for the Ford Preferred Series S issue disclosed that the "OID economic accrual" rules would apply in the event that the payment of preferred dividends was deferred. This issue is a hybrid--it is a preferred stock which pays interest rather than dividends. It has a cumulative preferred interest feature that must be paid in full before any common stock dividends may be paid. When Ford had to suspend the preferred interest payment, the issue automatically converted to an OID instrument.
OID refers to original issue discount, which is the concept that a note or bond that does not carry a stated or realistic rate of interest really has interest built in. IRS rules require current recognition of the unstated interest income, even if it is not collected until a future time. It is imputed interest, calculated according to the yield to maturity method.
Under the OID economic accrual rules, the uncollected interest was taxed to the holder of the security and added to the cost basis each year. When the interest was eventually collected (in 2011), the interest payment was a reduction of cost basis since it had already been taxed as interest income in previous years.
We advise you to audit your form 1099 carefully to ensure that the preferred stock OID was not double-reported by your broker/dealer--once as OID and again as interest income when it was collected.
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