Due Diligence Capital Notes

Here is a company that pays out regular quarterly distributions on four separate classes of preferred stock — 8% here, 10% there — and yet, when tax season rolls around, the IRS does not see a single dollar of those distributions as dividend income. Not one cent. Instead, every distribution Strategy Inc. paid to its preferred shareholders in 2025 was classified as a return of capital. To most investors, that phrase sounds like accounting sleight of hand. In reality, it is a precise, legally meaningful designation — and it tells you something important about how Strategy's Bitcoin accumulation model actually works under the hood.

On February 2, 2026, Strategy filed an 8-K with the SEC confirming that all 2025 distributions across its four preferred stock series — STRF, STRK, STRD, and STRC — would receive return-of-capital tax treatment for U.S. federal purposes. If you hold any of these instruments, this changes how you report your income and when you ultimately pay tax. But more broadly, this filing is a window into a structural tension at the heart of Strategy's model: a company sitting on billions of dollars of Bitcoin appreciation that, by conventional accounting, did not generate sufficient earnings in 2025.

What "Earnings and Profits" Actually Means

Before we get into the mechanics of Strategy's filing, we need to understand a concept that rarely gets explained outside of corporate tax courses: earnings and profits, or E&P. This is not the same as accounting net income, and it is not the same as free cash flow. E&P is the IRS's own measure of a corporation's economic capacity to make a dividend distribution — think of it as taxable distributable capacity. When a corporation's E&P is positive, distributions to shareholders are classified as ordinary dividend income. When E&P is zero or negative, distributions are instead classified as a return of capital, which means the IRS treats the payment not as profit being shared, but as the company returning part of your original investment.

Why would Strategy have insufficient E&P in 2025? Because Strategy's primary asset — Bitcoin — is measured on its balance sheet at fair market value under the new FASB accounting rules adopted in 2024, but unrealized gains on Bitcoin holdings do not create taxable income under current U.S. tax law. Strategy could hold 500,000 BTC that appreciated by $30 billion on paper in a single year, and that gain does not flow through to taxable E&P unless the Bitcoin is actually sold. Since Strategy's stated policy is to never sell Bitcoin, the company structurally struggles to generate the kind of conventional E&P that would support ordinary dividend classification.

This is not a scandal. It is a structural feature — or, depending on how you look at it, a structural constraint — of the Bitcoin accumulation playbook.

How the Four Preferred Series Work

Strategy currently runs four distinct classes of preferred stock, each listed on Nasdaq with its own terms:

STRF — 10% Perpetual Strife: A fixed 10.00% annual dividend rate on $0.001 par value shares, paid quarterly. Targeted at investors seeking a high fixed-yield instrument backed, indirectly, by Bitcoin as Strategy's primary asset.
STRK — 8% Perpetual Strike: An 8.00% fixed annual dividend, with a conversion option that allows holders to convert into common stock at a set future price. This is the series most similar to a traditional convertible preferred — it gives income investors the yield while preserving some upside optionality.
STRD — 10% Perpetual Stride: Another 10.00% fixed-rate preferred series, similar in structure to STRF. Strategy has used multiple series partly to access different institutional buyer pools.
STRC — Variable Rate Perpetual Stretch: Unlike the fixed-rate series, STRC carries a variable dividend rate, making it more analogous to floating-rate debt instruments. This appeals to a different class of investor — those managing interest-rate sensitivity in their portfolios.

All four series paid distributions in 2025. All four were reclassified as return of capital. That unanimous 100% ROC classification across every preferred series is the detail worth pausing on. This was not a partial shortfall or a single anomalous quarter. According to the February 2, 2026 filing signed by Executive Vice President and General Counsel Thomas C. Chow, Strategy "issued a press release on the U.S. tax treatment of 2025 preferred stock distributions and its expectations for future accumulated earnings and profits."

The phrase "expectations for future accumulated earnings and profits" is doing significant work in that sentence. Strategy is signaling, without quite promising, that the E&P picture is expected to improve — presumably because fair-value Bitcoin accounting gains may eventually flow through to recognized tax income under certain conditions, or because other business activities generate conventional E&P. But as of the end of 2025, the cupboard was empty.

The Tax Mechanics for Preferred Shareholders

So what does a return-of-capital classification actually mean for you if you hold STRF, STRK, STRD, or STRC?

No ordinary income tax at distribution time. Unlike a regular dividend — which you would typically report as ordinary income (or, if qualified, at the lower qualified dividend rate) in the year received — an ROC distribution is not taxable income when you receive it. On the surface, this sounds like a gift.
Reduced cost basis. Here is the catch. When you receive an ROC distribution, the IRS requires you to reduce your cost basis in the shares by the amount of the distribution. If you paid $25 per share for STRF and received $2.50 in 2025 distributions classified as ROC, your cost basis drops to $22.50 per share.
Higher capital gain on sale. The tax is deferred, not eliminated. When you eventually sell the shares, your capital gain is calculated against the reduced basis — so you pay more capital gains tax at that point. If the shares have appreciated, the eventual tax bill could be substantial. If the cost basis reaches zero through repeated ROC distributions, further ROC distributions become immediately taxable as capital gains.
Institutional investor friction. This is the practical market implication that matters most to Strategy's capital-raising strategy. Many institutional mandates — pension funds, insurance companies, certain trusts — require holdings to generate qualified dividend income, which is a specific tax category that ROC does not satisfy. An income fund that cannot count Strategy's preferred dividends as qualified income may not be able to hold these instruments at all. That narrows the buyer pool, which could pressure preferred stock prices and Strategy's ability to raise capital through future preferred issuances at attractive rates.

The filing itself acknowledges this tension obliquely in its forward-looking statement language: "Actual results may differ materially from those indicated by such forward-looking statements as a result of various important factors, including the uncertainties related to Strategy's future results of operations, its expectation regarding the tax-deferred return of capital treatment of dividends on Strategy's preferred stock, fluctuations in tax benefits or provisions, assumptions underlying Strategy's projections."

That is a dense sentence, but its core meaning is clear: Strategy is not certain it will ever generate the E&P needed to flip preferred distributions back to ordinary dividend status. The company is managing expectations while leaving itself legal room to miss.

You can review the full filing and the accompanying press release (Exhibit 99.1) at the SEC EDGAR index for this accession number. The primary risk disclosures underpinning this filing are cross-referenced to Strategy's October 6, 2025 8-K Risk Factor Updates and November 3, 2025 10-Q.

What This Reveals About the Model

The return-of-capital classification is, in a sense, the accounting system catching up with reality. Strategy's entire thesis rests on accumulating Bitcoin and never selling it. That means the company's enormous paper wealth — its Bitcoin holdings — generates no conventional taxable income stream. The preferred stock dividends are being funded by capital-raising activities (ATM offerings, convertible bond proceeds, new preferred issuances) rather than by operating earnings in the traditional sense. Of course the IRS sees this as return of capital. The IRS is right.

This does not make the model wrong. It makes the model what it has always been: a Bitcoin accumulation vehicle dressed in the clothing of a public company. The preferred stocks are instruments for converting fixed-income market demand into Bitcoin purchasing power. The common stock trades at a premium to its underlying Bitcoin value because investors are paying for the machine — the ongoing capacity to raise capital, buy Bitcoin, and repeat. None of that requires E&P in the IRS sense.

But the ROC classification does introduce a variable that preferred stock investors need to price carefully. If you are buying STRF for the 10% yield because you assume you are receiving ordinary income, you are making a modeling error. You are receiving a tax-deferred return of your own capital, which will be taxed as a capital gain when you sell — potentially at a much later date and a potentially different rate.

What Could Break This Thesis

Persistent E&P shortfall. If Bitcoin's mark-to-market gains never translate into taxable earnings — either because BTC stagnates, because Strategy never sells, or because tax law does not evolve to treat fair-value gains as income — the preferred dividends will remain in ROC territory indefinitely. That is a structural impediment to attracting the broadest institutional buyer base for these instruments. A narrower buyer pool means higher yield required, which means more dilution pressure on common shareholders to fund those coupons.

IRS or legislative reclassification. Congress or the IRS could change how unrealized Bitcoin gains are taxed, or could challenge Strategy's ROC classification retroactively. Either scenario could expose preferred shareholders to unexpected ordinary income liability and damage the preferred stock market — potentially triggering accelerated redemption provisions or investor exits.

Bitcoin price collapse. Strategy's entire capacity to service four series of preferred stock at 8%–10% fixed rates rests on its ability to raise capital, which in turn rests on investor confidence in Bitcoin. A prolonged bear market — not a 30% correction but a multi-year grind lower — would simultaneously reduce collateral value, tighten capital-market access, and stress the company's ability to fund distributions without diluting common shareholders aggressively.

Dividend obligation versus raising capacity mismatch. Four preferred series carrying fixed coupons of 8% to 10% represent a recurring capital obligation. If market conditions prevent Strategy from issuing new equity or bonds at favorable terms, funding those coupons becomes a balance sheet problem, not just a tax classification problem.

Conclusion

The February 2026 8-K is a relatively quiet filing — an administrative tax notice, not a capital raise or a Bitcoin purchase announcement. But I think it is one of the more illuminating documents Strategy has published in recent months, precisely because it is not trying to sell you anything.

What it reveals is this: Strategy has built a machine that converts investor demand for yield and Bitcoin exposure into an ever-growing BTC position. That machine works beautifully when Bitcoin is appreciating and capital markets are open. But the machine has a structural byproduct — the company does not generate conventional earnings in the IRS sense, which means the preferred distributions it pays are, technically, the company returning your capital and deferring your tax bill. Whether that is a feature or a bug depends entirely on your tax situation and your time horizon.

The more interesting signal is what Strategy says next. The filing explicitly references "expectations for future accumulated earnings and profits." That is a company watching the accounting rules around fair-value Bitcoin gains and anticipating — perhaps banking on — a future in which those paper gains become recognized income. If fair-value accounting eventually forces Bitcoin appreciation through to taxable E&P, the ROC classification disappears, the preferred stock becomes more attractive to a wider institutional audience, and Strategy's capital-raising capacity expands further. That is the forward-looking thesis embedded in a footnote of a routine tax filing. Worth watching.