The main benefit of preferred stock is its fixed dividend rate, which can provide steady income. Preferred stock typically pays dividends quarterly. For example:
An investor purchases 10,000 shares of a 5%, $100 par preferred stock
As long as the Board of Directors (BOD) declares the dividend, the investor will receive $50,000 per year in dividends:
Because preferred stock can generate substantial cash dividends, it’s often attractive to investors who want income.
Dividend payments aren’t guaranteed, which makes preferred stock riskier than debt securities. That added risk is one reason preferred stock may offer higher income than many bonds. In general, higher risk is associated with the potential for higher return.
Dividends from stock (common and preferred) are taxed at a lower rate than many other fixed-income investments. Most investors pay a 15% tax rate on dividends, while investors in the highest tax brackets pay 20%. By contrast, interest income from bonds is taxed at the investor’s ordinary income tax bracket (up to 37%). This makes dividend tax rates relatively low, especially for investors in higher tax brackets.
Corporate investors may receive even more favorable tax treatment. Under the corporate dividend exclusion rule, corporate investors can exclude (avoid paying taxes on) a portion of the 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 often invest through brokerage accounts on behalf of the company, which can result in owning shares of other companies. For example, assume General Electric (GE) owns a small portion of Coca-Cola (KO) stock. If Coca-Cola pays a $100,000 dividend to GE, GE will pay taxes on only $50,000 of that dividend. If GE owned 20% or more of Coca-Cola, GE would pay taxes on only $35,000 of the $100,000 dividend (a 65% exclusion).
Another dividend-related benefit is the “preferred” status preferred stock has over common stock. If a company pays a dividend to common stockholders, it must pay preferred stockholders first. If the preferred shares are cumulative, the issuer must also pay any previously skipped preferred dividends before paying a common stock dividend.
Preferred stock also has priority over common stock in a liquidation. Preferred stockholders are paid after items such as unpaid wages, unpaid taxes, and bondholders, but they receive liquidation proceeds before common stockholders.
Other benefits of preferred stock come from specific features. In particular, participating and convertible preferred stock can increase an investor’s return potential.
If the issuer has a strong year, participating preferred stock may receive dividends above the stated rate. This feature lets the investor “participate” in the company’s financial success. Non-participating preferred stock pays the stated dividend rate regardless of company performance.
Conversion features provide another way to potentially earn more than the stated dividend rate. Convertible preferred shares can be converted into the issuer’s common stock, and common stock prices tend to rise when the issuer is successful and demand for the stock increases. Convertibility adds capital appreciation potential, which is generally not a meaningful benefit of non-convertible preferred stock.
A capital gain is possible with preferred stock, but it’s generally less likely than with common stock. Preferred stock prices are usually influenced more by interest rate movements than by the company’s operating success.
If the shares are not participating or convertible, the dividend rate is fixed and doesn’t change, no matter how well the company performs. In most cases, non-participating, non-convertible preferred stock appreciates mainly when interest rates fall. Because interest rate movements are difficult to predict, investors typically don’t buy preferred stock expecting significant capital gains.
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