How is preferred stock classified for tax purposes?
Most preferred stock dividends are treated as
- Cumulative. Most preferred stock is cumulative, meaning if the company withholds part or all of the expected dividends, they are considered dividends in arrears and must be paid before any other dividends. ...
- Callable. ...
- Convertible. ...
- Participating. ...
- Adjustable-Rate Preferred Stock (ARPS).
Dividends on preferred shares are taxable income, but the tax rate you pay depends on whether the IRS considers the dividends to be "qualified." Qualified dividends are taxed at lower rates than ordinary income. For 2023 and 2024, the tax rate ranges from 0 % to 20% depending on your tax bracket.
Preferred stock is equity. Just like common stock, its shares represent an ownership stake in a company. However, preferred stock normally has a fixed dividend payout as well. That's why some call preferred stock a stock that acts like a bond.
To comply with state regulations, the par value of preferred stock is recorded in its own paid-in capital account Preferred Stock. If the corporation receives more than the par amount, the amount greater than par will be recorded in another account such as Paid-in Capital in Excess of Par – Preferred Stock.
A, B, and F
Common Stock and Preferred Stock are sometimes referred to as Class A and Class B Shares, respectively. But these are not the only classes. A new breed of stock called Class F Shares (F for Founder) created by The Founder Institute is slowly becoming more common.
Taxation of Conversion: When the convertible preferred stock is converted into common stock, it is generally not a taxable event. However, if the conversion price is below the fair market value of the common stock at the time of conversion, the difference may be considered taxable income.
Preferred dividends generally are taxed favorably, like those on common stock, at a maximum federal rate of 23.8% (including the Medicare surcharge), while corporate debt is taxed as ordinary income at a maximum federal rate of 37%. A 7.5% preferred yield is equivalent to more than 9% on a corporate bond.
Pros and cons of preferred stocks
On the downside, there is a limit on how much the investment can appreciate because of its call feature. Issuers often call preferred bonds in low-interest rate environments so they can reissue a stock that pays a lower dividend.
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.
Are preferred stock dividends tax deductible?
Preferred Stock: No Tax Advantage
Like common stock dividends, preferred share dividends are distributions of profits, not interest payments. The IRS does not consider distributions of profits tax-deductible.
What are preferred securities? Traditional preferred securities (“preferreds”) are fixed-income investments with equity-like features mainly issued by large banks and insurance companies.
On the pro side, some of the best reasons to consider preferred stock include: Consistent dividend income, with fixed payout amounts and payment dates. First priority to receive dividend payouts ahead of common stock shareholders or creditors. Potential for larger dividends, compared to common stock shares.
Preferred stock, common stock, additional paid‐in‐capital, retained earnings, and treasury stock are all reported on the balance sheet in the stockholders' equity section.
Generally Accepted Accounting Principles (GAAP) provide a standard method for accounting for preferred stock. Preferred stock is accounted for as equity. Under GAAP, the equity section of the balance sheet should include: Common Stock: Represents shares purchased by employees, founders, (and public investors post-IPO).
The amount received from issuing preferred stock is reported on the balance sheet within the stockholders' equity section. Only the annual preferred dividend is reported on the income statement.
Class A, common stock: Each share confers one vote and ordinary access to dividends and assets. Class B, preferred stock: Each share confers one vote, but shareholders receive $2 in dividends for every $1 distributed to Class A shareholders. This class of stock has priority distribution for dividends and assets.
Similar to common shareholders, those who purchase preferred shares will still be buying shares of ownership in a company.
A preferred stock is a class of stock characterized by a set dividend payment with a rate of return comparable to a bond. Preferred stock also has priority in bankruptcy liquidation, but doesn't have any voting rights. It's looked at as a hybrid investment that has equity, but acts like a bond.
Convertible preferred shares give their holders the option of converting them into a set amount of common stock shares in the future. This gives the shareholder the potential benefit of capital appreciation in addition to the guaranteed benefit of a regular dividend.
Does preferred stock have capital gains?
Most preferred stock dividends are treated as qualified dividends, meaning they are taxed at the more favorable rate of long-term capital gains. Some preferred stock dividends are not qualified, however.
Convertible preferred shares can be converted into common stock at a fixed conversion ratio.
In its basic form, the calculation is net income − preferred stock dividends divided by number of shares of common stock outstanding. Preferred dividends are removed from the net income amount since they are distributed prior to common shareholders having any claim on company profits.
Preferred stock must have a holding period of at least 90 days during the 180-day period that begins 90 days before the stock's ex-dividend date. Holding also applies when receiving new stock in a company spun off from the original company in which the investor purchased stock.
Preferred Stock ETF | Dividend Yield* | Expense Ratio |
---|---|---|
Global X U.S. Preferred ETF (PFFD) | 6.3% | 0.23% |
iShares Preferred and Income Securities ETF (PFF) | 6.5% | 0.46% |
First Trust Preferred Securities and Income ETF (FPE) | 5.9% | 0.84% |
Invesco Preferred ETF (PGF) | 5.5% | 0.56% |