The primary benefit of preferred stock is the fixed dividend rate that provides income to investors. As you already know, preferred stock typically makes quarterly dividend payments to investors. For example:
An investor purchases 10,000 shares of a 5%, $100 par preferred stock
As long as the Board of Directors (BOD) approves the payment, this investor will receive $50,000 a year in dividends from this investment (5% x $100 par x 10,000 shares). The ability for an investment to provide substantial cash dividends is a huge benefit to investors seeking income, especially those who are retired and looking to replace the income from their former jobs.
While there’s no guarantee that dividend payments will occur, this results in higher rates of return than debt securities. Remember, more risk typically results in higher returns. For an income-seeking investor willing to absorb a little risk in return for higher amounts of income, preferred stock can be a suitable choice.
Dividends from stock (common and preferred) are taxed at a lower rate than many other fixed-income securities. Most investors pay a 15% tax on dividends, while those at the highest tax brackets pay 20%. Interest income from bonds is taxed at the investor’s income tax bracket (up to 37%), making dividend tax rates relatively low. This benefits all stock investors, especially those at high tax brackets.
Corporate investors obtain even more tax benefits than individual investors. Known as the corporate dividend exclusion rule, corporate investors avoid paying taxes on large portions of dividends they receive. This rule applies to both preferred and common stock dividends.
*This rule only applies to corporations structured as C-corps and does not apply to S-corps or any other business form. Various business structures are discussed later in this material.
In particular, corporations can avoid paying taxes on:
Corporations typically maintain brokerage accounts where they invest money for the benefit of the company. When this occurs, these corporations end up owning portions of other companies. For example, let’s assume General Electric (GE) owns a small portion of Coca-Cola (KO) stock. If Coca-Cola makes a dividend payment of $100,000 to GE, GE will only pay taxes on $50,000. If GE owned 20% or more of Coca-Cola, they would only pay taxes on $35,000 of the $100,000 dividend payment (65% exclusion).
Another benefit relating to dividends is the “preferred” status preferred stock has over common stock. If the company wants to make a dividend payment to common stockholders, preferred stockholders must be paid prior. If the shares are cumulative, the issuer must additionally make up all prior skipped dividends prior to a common stock dividend disbursement. Preferred stock also maintains priority over common in the event of a liquidation. While they’re below unpaid wages, unpaid taxes, and bondholders, preferred stockholders will receive proceeds from a corporate liquidation prior to common stockholders.
Other benefits of preferred stock relate to its features. In particular, participating and convertible preferred stock increase the return potential for investors.
If the issuer has a successful year, participating preferred stock is eligible to receive a higher dividend rate than the stated rate. This feature allows the investor to “participate” in the company’s financial success. Non-participating preferred stock pays the same dividend rate, regardless of how well the company performs.
Conversion features provide another way for an investor to obtain a higher return than the stated dividend rate. These preferred shares can convert to common stock of the same issuer, and common stock market values are directly related to the issuer’s success. When a company’s product or service line is successful, the common stock price tends to increase due to higher demand for the company’s common stock. Convertibility provides capital appreciation potential, which is not a typical or significant benefit of non-convertible preferred stock.
While a capital gain is certainly possible with preferred stock, it’s less likely to occur as compared to common stock. Preferred stock market prices are generally influenced by interest rate movements, not the successes of the company. If the shares are not participating or convertible, the dividend rate is fixed and does not change, no matter how well the company performs. In most cases, preferred stock does not appreciate in price unless interest rates fall. Interest rate fluctuations are difficult to predict, so investors generally do not expect capital gains from their preferred stock investments.
Sign up for free to take 8 quiz questions on this topic