Preferred stock is a class of ownership in a corporation that provides a higher claim on its assets and earnings as compared to common stock. There is no direct tax advantage to the issuing of preferred shares when compared to other forms of financing such as common shares or debt. Still, there are several reasons why a company chooses to offer preferred stock, all of which relate to the financial advantages that it provides.

Key Takeaways

  • Preferred shares are a hybrid form of capital issued by firms that are equity-based but pay out a stable dividend as if they were debt.
  • Because the dividends paid out use after-tax dollars, preferred shares do not offer the firm an immediate tax deduction, as interest paid on debt would.
  • There are still several benefits to a company for issuing preferred shares such as no voting rights to shareholders, ease of raising capital, and no additional debt load.

What Is Preferred Stock?

Preferred stock derives its name from the fact that it carries a higher privilege by almost every measure in relation to a company's common stock. Preferred stock owners are paid before common stock shareholders in the event of the company's liquidation. Preferred stockholders enjoy a fixed dividend that, while not absolutely guaranteed, is nonetheless considered essentially an obligation the company must pay.

Preferred stockholders must be paid their due dividends before the company can distribute dividends to common stockholders. Preferred stock is sold at par value and paid a regular dividend that is a percentage of par. Preferred stockholders do not typically have the voting rights that common stockholders do, but they may be granted special voting rights.

Why There Is No Direct Tax Advantage

Preferred shares do not actually offer the issuing company a direct tax benefit. The reason for this is that preferred shares, which are a form of equity capital, are owed fixed cash dividends that are paid with after-tax dollars. This is the same case for common shares. If dividends are paid out, it is always using after-tax dollars—and thus does not offer a current tax deduction.

Preferred shares are considered to be like debt in that they pay a fixed rate like a bond (a debt investment). It is because interest expenses on bonds are tax-deductible—while preferred shares pay with after-tax dollars—that preferred shares are considered a more expensive means of financing.

Issuing preferred shares does have its benefits over bonds in that a company can stop making payments on preferred shares where they are unable to stop making payments on bonds without going into default.

Why Issuing Preferred Shares Benefits Companies

There are several reasons why issuing preferred shares are a benefit for companies. Preferred stock provides a simpler means of raising substantial capital than the sale of common stock does. The par value that companies offer preferred stock for is often significantly higher than the common stock price.

Companies often offer preferred stock prior to offering common stock, when the company has not yet reached a level of success that would make it sufficiently attractive to large numbers of retail investors. The sale of preferred stock then provides the company with the capital necessary for growth.

Preferred stock also offers companies some financial flexibility. Dividends owed to preferred stockholders can be deferred for a time if the company should experience some unexpected cash flow problems.

The deferred dividends are essentially considered to be owed to the preferred stockholders, payable at some point in the future, but their deferral may be critical in helping a company bridge the gap over a period of financial difficulty. This is one way in which preferred stock is distinguished from bonds since a company not making the interest payment due on a bond would ordinarily be considered to be in default and thus risking bankruptcy.

One benefit of issuing preferred shares is that for financing purposes they do not reflect added debt on the company's financial books—after all, it's still equity. This actually can save money for the company in the long run. When the company looks for debt financing in the future, it will receive a lower rate since it will appear the company's debt load is lower, causing the company to in turn pay less on future debt.

Preferred shares also tend not to have voting rights, so they create another benefit in that issuing preferred shares does not dilute the voting rights of the company's common shares.