Investing Portfolio Management Preferred Stock on an Income Statement By Joshua Kennon Joshua Kennon Twitter Website Joshua Kennon is an expert on investing, assets and markets, and retirement planning. He is the managing director and co-founder of Kennon-Green & Co., an asset management firm. learn about our editorial policies Updated on May 31, 2022 Reviewed by Michael J Boyle Reviewed by Michael J Boyle Michael Boyle is an experienced financial professional with more than 10 years working with financial planning, derivatives, equities, fixed income, project management, and analytics. learn about our financial review board Fact checked by Julian Binder In This Article View All In This Article How Does Preferred Stock Relate to Net Income? Understanding the Nature of Preferred Stock The Bottom Line Frequently Asked Questions (FAQs) Photo: SEC Archives Encore Bancshares, 1319327/000119312508249561 Whether you're a new or experienced investor, you may have a hard time explaining what preferred stock is and how it affects a company's worth. Many people are familiar with common stock, but preferred stock is different; it has qualities of both a stock and a bond. Preferred stocks typically pay fixed dividends, which are distributions of company profits. Preferred stock dividends play a role in understanding income statements. Learn about the role of preferred stock on an income statement, and find out how it influences the reported profit and loss in companies that have issued a large amount of it. How Does Preferred Stock Relate to Net Income? An income statement is a type of financial statement. It includes a company's revenues, expenses, gains and losses, and net income, which is the total after-tax profit made for the period. It is calculated before deducting the required dividends paid on the outstanding preferred stock. You can't completely rely on reported net income as it appears at this point, though, because of the nature of preferred stock and its dividends. Regular cash dividends paid on common stock are not deducted from the income statement. For example, suppose a company made $10 million in profit and paid $9 million in dividends. The income statement would show $10 million, and the balance sheet would show $1 million. The cash flow statement would show $9 million in dividends distributed. Preferred stock dividends are deducted on the income statement. The reason is that preferred stockholders have a higher claim to dividends than common stockholders do. Many companies include preferred stock dividends on their income statements; then, they report another net income figure known as "net income applicable to common." Now, suppose a company earned $10 million after taxes and paid $1 million in preferred stock dividends. The net income applicable to common would show only $9 million on the income statement. Understanding the Nature of Preferred Stock In essence, preferred stock acts like a mixture of a stock and a bond. Each preferred share is normally paid a guaranteed, fairly high dividend. If the company ever goes bankrupt or is liquidated, preferred stock will be ranked higher in the capital structure to receive any leftover distributions but behind the bondholders and certain other creditors. In exchange for this higher income and relative safety, preferred stockholders are not entitled to share in the business's success beyond the dividend, unless they hold a special type, known as "participating preferred stock." Even then, it won't be comparable to common stock. Rather, in a highly successful enterprise, as long as things go well year after year, you will collect your preferred dividends, but the common stockholders will earn significantly more. NOte Preferred stockholders may or may not have voting rights. Some companies issue many different types of preferred stock all at once. These may include adjustable-rate preferred stock, convertible preferred stock, first preferred stock, participating preferred stock, participating convertible preferred stock, prior preferred stock, and second preferred stock. Each preferred share may have its own dividend rate or par value, so before finding the "true" net income, dividends from all of these shares need to be deducted from net income on the income statement. That is because, in nearly every instance, corporation bylaws forbid the payment of any dividend on the common stock unless the dividend on the preferred stock has been paid. Let's look at it from the perspective of a common stock investor. The preferred stock dividends are required payments that must be made before it becomes possible to receive some of the business earnings and enjoy them. Preferred stock dividends are every bit as real of an expense as payroll or taxes. The Bottom Line Preferred stocks have stability without the potential payout that common shares have. It comes from being first in line for dividends. Firms include preferred stocks on income statements. Frequently Asked Questions (FAQs) How are preferred stock dividends taxed? Preferred dividends are typically held long-term, so the dividends are often taxed at the lower "qualified dividend" rate. Qualified dividends are taxed at the capital gains rate. In most cases, if preferred stock shares are owned less than 61 days before they pay a dividend, then the income is instead taxed at regular income rates. How do you buy preferred stock? Preferred stock can be purchased in a process that is similar to buying any other stock. However, you might need to use a specialized screener to find them, and not all brokerages will offer the preferred stocks you want. For example, Fidelity offers preferred stocks to its customers, but you'll need to select the "preferred securities" screener rather than the "stocks" screener to start your search. Was this page helpful? Thanks for your feedback! Tell us why! Other Submit Sources The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy. Michigan State University. "The Peril and Promise of Preferred Stock," Page 167. U.S. Securities and Exchange Commission. "Bankruptcy: What Happens When Public Companies Go Bankrupt." Internal Revenue Service. "Topic No. 404 Dividends." Internal Revenue Service. "Instructions for Form 1099-DIV," Page 2. Fidelity. "Security & Stock Screeners."