Common Stock vs. Preferred Stock

by David Carnes

    Corporate stock represents an ownership stake in a company. Common stock and preferred stock are the two most common forms of corporate ownership. Although every stock corporation issues common stock, only some issue preferred stock. Preferred stock is subject to special terms that offer both advantages and disadvantages to the stockholder compared with common stock.

    Voting Rights

    Holders of common stock enjoy voting rights on the major corporate policy issues that must be presented to the shareholders -- the appointment of new directors, for example, or the issuance of new shares. Voting is not based on a "one man, one vote" system, but on a "one share, one vote" system -- if you hold 5 percent of the shares in the corporation, you are entitled to one-twentieth of the total votes. Holders of preferred stock typically are not entitled to vote at all.

    Dividends

    Dividends are amounts periodically distributed to stockholders out of corporate income. Common stockholders do not know the value of their dividends in advance or even if they will receive dividends at all -- they must wait for an announcement by the board of directors. Preferred stockholders, by contrast, enjoy a guaranteed dividend that is described in their stock purchase agreement. However, this doesn't necessarily mean that preferred stockholders receive higher dividends than common stockholders.

    Risks

    The price of common stocks tends to be more volatile than the price of preferred stocks, according to Mitch Schlesinger, managing director of FBB Capital Partners. Nevertheless, over the long term, common stocks enjoy higher average returns. Average dividends are higher for preferred stock, and preferred shareholders enjoy a superior right to dividends over common stockholders. Some preferred stockholder agreements give the corporation the right to buy back preferred stock at a certain price at any time, even over the objections of the stockholder.

    Corporate Bankruptcy

    If a corporation files for Chapter 7 bankruptcy, its assets are liquidated and distributed to its creditors in a particular order of preference, after which point the company ceases to exist. Common shareholders are the lowest priority creditors -- they receive a share of company assets only after all other creditors, including preferred stockholders, have been paid. In most Chapter 7 bankruptcy cases, common shareholders get nothing, while preferred shareholders have a chance to obtain at least partial compensation for their investment in the corporation.

    Tax Implications

    Ordinary corporations are subject to double taxation -- corporate income is taxed once at the corporate level and again when stockholders receive income, such as dividends, from the corporation. The IRS allows qualifying corporations to opt for "S corporation" tax status, in which corporate income is not taxed at the corporate level. One restriction on S corporation status, however, is that it must issue only one class of stock. This means that corporations that issue preferred stock cannot qualify as S corporations. Taxation at the corporate level can reduce stock prices and funds available for dividends.

    Photo Credits

    • dollars... dollars... image by Slyadnyev Oleksandr from Fotolia.com

    About the Author

    David Carnes has been a full-time writer since 1998 and has published two full-length novels. He spends much of his time in various Asian countries and is fluent in Mandarin Chinese. He earned a Juris Doctorate from the University of Kentucky College of Law.

    Zacks Investment Research

    is an A+ Rated BBB

    Accredited Business.