Preferred stock are shares issued from a company that have priority in receiving dividends and other benefits over common stock. The exact benefits offered by a preferred stock may vary, but all have some form of priority over common stockholders. When issued, the preferred dividends are listed numerically or as a percentage of the issuance price. The dividends are not a guaranteed repayment like that of a bond, but given their seniority, they have more stable income than that of the common stock. Typically, preferred shares will receive value for their stocks if the company dissolves prior to common stock but after creditors and bondholders. A company can issue numerous types of preferred stock with varying levels of seniority and dividend payouts.
Commonly, preferred stockholders do not have voting rights in the company as common shareholders do. Also, preferred stock, when issued, contains conversion or buyback clauses that allow the company to buy back the preferred stock at a certain price or force the preferred stock to rollover into common stock.
Preferred stock can also have numerous tax implications. Generally, preferred stock dividends, even though having characteristics of bonds, are taxed at the lower capital gains tax rate than at normal income levels as long as they qualify. However, preferred stock have complex treatment under the tax code and can be treated in different ways than common stock. For federal tax purposes, preferred stock must meet numerous different requirements that vary depending upon how a preferred stock is being used. For example, to be treated as a preferred stock under Internal Revenue Code (IRC) § 1504(a)(4) the stock must be nonvoting, but under 26 CFR § 1.305-5, there is not a nonvoting requirement. Generally, to be treated as preferred stock, the shares must 1) have some limited preferential treatment and 2) “does not participate in corporate growth to any significant extent” (See 26 CFR § 1.305-5).
[Last updated in October of 2023 by the Wex Definitions Team]
