What Are Preferred Dividends and How Do They Work?

Dividends represent a portion of a company’s earnings distributed to its shareholders. While common stock dividends can fluctuate based on a company’s performance, preferred dividends offer a distinct approach to shareholder returns. These specific dividends are tied to preferred stock, a class of equity that combines certain features of both stocks and bonds. They are designed to provide a more predictable income stream for investors.

What Are Preferred Dividends?

Preferred dividends are payments made by a company to its preferred shareholders. They hold a priority claim over common stock dividends. Companies must pay preferred dividends before any distributions to common shareholders. This ensures preferred stockholders receive their payments first from available earnings. In situations where a company cannot pay all dividends, preferred dividends take precedence.

Preferred dividends are typically determined in advance, often as a fixed percentage of the stock’s par value. This fixed rate provides predictability for investors seeking consistent income. The total annual preferred dividend is calculated by multiplying the dividend rate by the par value, and this amount is then divided into periodic payments, commonly quarterly.

Key Characteristics

Preferred dividends possess distinct features that differentiate them from common stock dividends. They typically offer a fixed dividend rate, meaning the payment amount remains constant over time, unlike common stock dividends. This fixed payment is expressed as a percentage of the preferred stock’s par value, providing a predictable income stream. For instance, a 5% preferred stock with a $100 par value would pay a $5 annual dividend.

A significant distinction lies in whether they are cumulative or non-cumulative. With cumulative preferred stock, if a company misses a dividend payment, the unpaid amount accumulates and must be paid to shareholders in arrears before any dividends can be distributed to common stockholders. This feature provides protection for investors, ensuring missed payments are eventually recovered. In contrast, non-cumulative preferred dividends do not accumulate missed payments; if a dividend is not declared, it is lost and does not need to be paid. Most preferred stock offerings include the cumulative feature, as it reduces risk for investors.

Preferred stock typically does not carry voting rights, a trade-off for the dividend priority and stability it offers. Common stockholders usually have voting rights, allowing them to participate in corporate governance, such as electing board members. While some preferred shares may gain limited voting rights if dividends are significantly in arrears, the general characteristic is a lack of voting power.

Why Companies Issue Preferred Stock

Companies issue preferred stock for various strategic reasons, primarily as a financing tool. It serves as a method for raising capital without diluting the ownership or voting control of existing common shareholders. Issuing common stock would increase voting shares, potentially shifting control, which preferred stock avoids.

Preferred stock can also be an alternative to traditional debt. While it provides capital, it does not add to the company’s debt-to-equity ratio in the same way bonds do, which can make the balance sheet appear stronger. Unlike bond interest payments, preferred dividends are not a legal obligation that could lead to default if missed, offering companies more financial flexibility.

Preferred stock can attract a distinct group of investors. These securities appeal to those seeking a stable income stream rather than significant capital appreciation. By offering preferred stock, companies can broaden their investor base, attracting those who value predictable returns and dividend priority.

Investor Considerations

For individual investors, preferred dividends offer several appealing aspects. The primary draw is the stable income stream from fixed dividend payments, attractive for those seeking regular cash flow. Preferred shareholders also hold priority over common shareholders in receiving dividends and, in liquidation, have a higher claim on company assets after bondholders. This liquidation preference provides added security compared to common stock.

The taxation of preferred dividends in the United States is a significant consideration. Preferred dividends are classified as either “qualified” or “non-qualified” for tax purposes, which dictates their tax treatment. Qualified dividends typically receive favorable tax treatment, taxed at the lower long-term capital gains rates (0% to 20% depending on income bracket). To be considered qualified, dividends must meet specific Internal Revenue Service (IRS) criteria, including a holding period requirement (holding the stock for at least 61 days within a 121-day period around the ex-dividend date).

Non-qualified dividends are taxed at an investor’s ordinary income tax rates, which can be substantially higher (up to 37% for the highest income brackets). Certain types of dividends, such as those from real estate investment trusts (REITs) or those not meeting holding period rules, are examples of non-qualified dividends. Investors receive IRS Form 1099-DIV, which specifies whether dividends are qualified (Box 1b) or ordinary (Box 1a).