For investors, preferred stock has similarities to common stock and is taxed the same way, except in special situations. Companies use a variety of financing options to get the funding they need to increase their business. Public companies have significantly more options than private ones for equity and debt, and preferred stock is one such option.
Preferred stock has characteristics similar to both stocks and bonds. As a holder of preferred stock, you receive dividends before common stockholders do. Typically, preferred stock does not come with voting rights. This is less of a concern to individual investors, who tend to have little impact on the voting outcomes because of the relatively tiny proportion of shares they own. Although preferred stockholders typically receive a relatively fixed dividend, if the company's earnings grow significantly, it may increase its common stock dividends but keep the preferred stock dividends the same. Preferred stock lists separately and trades at a different price from common stock.
Preferred shares pay dividends or interest, typically on a quarterly or semiannual basis. As an investor who owns preferred shares through your broker, at the end of the tax year you will receive a Form 1099-INT or 1099-DIV documenting the dividend or interest payments you received on the preferred stock you own. Because you're an individual, the dividends and interest you receive on your preferred stock investments are taxable at your regular income tax rate.
Tax rules differ in certain situations. Some trust-preferred stock has a deferrable feature. On these shares, the issuer may defer the payment of dividends or interest for up to five, 10 or more years without triggering default. In this case, as an investor, you are liable for the taxes in the year the amounts were accrued and deferred. Although you haven't received any dividend payments, you must still pay income taxes on the amounts you would have received if the issuer had paid out the funds. In the year you receive the payments, you would owe income taxes on that year's accrued payments only.
Certain institutions and corporations reap additional tax benefits from the ownership of preferred shares. Tax laws allow up to 70 percent of dividends received from preferred shares to be tax-exempt. Individuals reap no such benefits. However, you may get tax benefits from investing in preferred shares of qualified domestic corporations you held for a designated holding period. As of 2013, you are taxed on this "qualified dividend income" at your applicable capital gains rate. This may be lower than your regular income tax rate.
Tiffany C. Wright has been writing since 2007. She is a business owner, interim CEO and author of "Solving the Capital Equation: Financing Solutions for Small Businesses." Wright has helped companies obtain more than $31 million in financing. She holds a master's degree in finance and entrepreneurial management from the Wharton School of the University of Pennsylvania.