Do Preferred Shares Offer Companies a Tax Advantage?

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Do Preferred Shares Offer Companies a Tax Advantage?

Preferred stock is a kind of stock that has a larger claim on a company’s assets and profits than regular stock. When compared to other kinds of funding such as ordinary stock or debt, there is no direct tax benefit to issuing preferred stock. Still, there are various reasons why a corporation decides to sell preferred stock, all of which are financial in nature.

Key Takeaways

  • Preferred shares are a kind of hybrid capital issued by corporations that are equity-based yet pay a fixed dividend like debt.
  • Because dividends are paid out using after-tax cash, preferred shares do not provide the corporation with an instant tax benefit, as debt interest would.
  • There are still some advantages to issuing preferred shares to a corporation, such as no voting rights for shareholders, simplicity of acquiring cash, and no extra debt burden.

What Is Preferred Stock?

Preferred stock gets its name from the fact that it has a greater privilege than ordinary stock in practically every metric. In the case of the company’s collapse, preferred stockholders get compensated before common stockholders. Preferred investors get a predetermined dividend that, although not totally guaranteed, is still seen as an obligation that the firm must meet.

Before the corporation may deliver dividends to ordinary shareholders, preferred investors must be paid their respective dividends. Preferred stock is offered at par and pays a regular dividend based on a percentage of par. Preferred investors normally do not have the same voting rights as regular stockholders, although they may be given unique voting privileges.

Why There Is No Direct Tax Advantage

Preferred shares do not provide a direct tax advantage to the issuing corporation. The rationale for this is that preferred shares, a kind of equity capital, are entitled to fixed cash dividends paid using after-tax revenues. The same is true for common stock. Dividends are always paid out after-tax money, and hence do not provide a current tax reduction.

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Preferred shares are similar to debt in that they pay a set rate of return, similar to bonds (a debt investment).Because bond interest is tax-deductible, and preferred shares pay with after-tax cash, preferred shares are regarded a more costly type of financing.

Issuing preferred shares has an advantage over issuing bonds in that a corporation may cease making payments on preferred shares without going into default, but a firm cannot stop making payments on bonds without going into default.

Why Issuing Preferred Shares Benefits Companies

There are various reasons why corporations should issue preferred stock. Preferred stock is a more straightforward way to raise considerable money than ordinary stock. The par value of preferred shares offered by firms is sometimes much greater than the ordinary stock price.

When a firm has not yet achieved a degree of success that would make it appealing to a significant number of retail investors, it is typical for it to issue preferred stock before it issues ordinary stock. The proceeds from the sale of preferred shares are then used to fund the company’s expansion.

Preferred stock also provides financial flexibility to businesses. Dividends owing to preferred investors might be delayed for a period of time if the firm has unanticipated cash flow challenges.

Deferred dividends are generally regarded owing to preferred investors and will be paid at some time in the future, but their delay may be vital in helping a firm bridge the gap during a moment of financial trouble. This is one way preferred stock differs from bonds, since a firm that fails to make the interest payment due on a bond is regarded to be in default, putting it at danger of bankruptcy.

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One advantage of issuing preferred stock is that it does not increase debt to the company’s books for financing purposes—after all, it is still equity. In the long term, this may save the firm money. When the firm seeks debt financing in the future, it will obtain a cheaper rate since the company’s debt burden seems to be smaller, leading the company to pay less on future debt.

Preferred shares typically do not have voting rights, therefore issuing preferred shares does not reduce the voting rights of the company’s ordinary shares.

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