A preference dividend is a payment made to holders of preferred stock before any dividend goes to common stockholders

When a company decides to distribute profits to shareholders, it follows a legal order. Preferred stockholders get paid first. Common stockholders get paid only after preferred dividends are fully distributed — and only if money remains. This priority is written into the company's charter and the terms of the preferred stock itself.

Preference dividends are not optional or discretionary. Once a company declares a dividend, preferred shareholders have a contractual right to receive their stated amount. The company cannot skip preferred dividends to pay common ones, and it cannot reduce a preferred dividend to increase a common one.

Key Takeaways

  • Preferred stockholders receive their dividend payments before common stockholders receive anything, regardless of how much profit the company made.
  • The dividend rate for preferred stock is usually fixed at the time of purchase and does not change, making it more predictable than common dividends.
  • If a company runs out of money before paying all preferred dividends, those unpaid amounts typically accumulate and must be paid before common dividends resume.
  • Preferred dividends are paid from after-tax corporate profits, so the company must earn enough to cover them after all expenses and taxes.

How the payment order works in practice

A company's board of directors votes to declare a dividend. That declaration specifies how much will go to each class of stock. The company then sets a record date — the day you must own the stock to receive the payment — and a payment date when the money actually transfers.

On payment day, the company pays preferred dividends first. If $10 million in preferred dividends are owed and the company has $15 million to distribute, preferred shareholders get their full $10 million. The remaining $5 million goes to common shareholders. If the company only has $8 million, preferred shareholders still get their full $10 million, and common shareholders get nothing — the company must find the additional $2 million or borrow it.

This priority applies even during financial stress. A company in decline must still honor preferred dividends before it can pay common ones. This is why preferred stock is considered lower-risk than common stock: you know what you will receive and when, assuming the company stays solvent.

Cumulative versus non-cumulative preference dividends

Most preferred stock is cumulative, meaning if the company skips a dividend payment, that amount is owed and accumulates. The company cannot resume paying common dividends until all back preferred dividends are paid in full. This protects preferred shareholders during temporary cash shortages.

Some preferred stock is non-cumulative, meaning skipped dividends are simply lost — they do not accumulate and do not have to be paid later. Non-cumulative preferred stock is riskier and typically pays a higher dividend rate to compensate. Most individual investors encounter cumulative preferred stock.

You can find whether your preferred stock is cumulative in the prospectus or the company's investor relations materials. The distinction matters most during downturns, when companies often suspend dividends temporarily.

Fixed rates and how they differ from common dividends

Preferred dividends are almost always fixed — the company commits to paying a specific dollar amount or percentage of the stock's par value each year. If you own $1,000 of 5% preferred stock, you receive $50 per year, every year, regardless of company performance.

Common dividends, by contrast, fluctuate. A company might pay $2 per share one year and $0.50 the next, or nothing at all. The board can raise, lower, or suspend common dividends at will. Preferred dividends cannot be cut without amending the stock's terms — a major legal step that requires shareholder approval and often triggers lawsuits.

This fixed nature makes preferred stock behave more like a bond than like common stock. You trade the upside of rising dividends for the security of a may provide payment. If the company thrives, common shareholders benefit far more. If the company struggles, preferred shareholders are protected.

What happens if the company cannot pay

If a company runs out of cash and cannot pay its preferred dividends, it is in breach of its obligations to preferred shareholders. The consequences depend on the stock's terms and the company's financial state.

In many cases, preferred shareholders gain voting rights they did not have before — they can vote on major decisions like selling the company or taking on debt. Some preferred stock includes a provision that the company must negotiate with preferred shareholders before paying any common dividend if preferred dividends are in arrears. In severe cases, preferred shareholders can force the company into bankruptcy proceedings to recover what they are owed.

This protection is why preferred stock is senior to common stock in a bankruptcy. If a company liquidates, preferred shareholders are paid from the proceeds before common shareholders receive anything. Creditors and bondholders are paid first, but preferred shareholders rank ahead of common equity.

Participating versus non-participating preferred dividends

Most preferred stock is non-participating, meaning you receive only your fixed dividend. You do not share in extra profits if the company performs exceptionally well.

Participating preferred stock allows you to receive your fixed dividend plus a share of additional profits beyond a certain threshold. This is rare in public companies but common in venture capital and private equity deals. If you own participating preferred, your prospectus will state the participation formula clearly.

For most individual investors buying preferred stock through a brokerage, non-participating is the standard. The fixed payment is the entire benefit — there is no upside participation, but there is also no downside surprise.

Tax treatment of preference dividends

Preference dividends are taxed as ordinary income to the shareholder in the year they are received, unless the preferred stock qualifies for the lower "may have access to dividend" tax rate. The rules for may have access to dividends are complex and depend on how long you held the stock and the company's tax status.

Most preferred stock issued by U.S. corporations qualifies for the lower rate if you meet the holding period requirement — typically 60 days around the ex-dividend date. Check your brokerage statement or the company's investor relations site to confirm the tax treatment of your specific preferred shares.

The company does not withhold taxes on preferred dividends the way it does on wages, so you may owe estimated taxes if you receive large dividend payments. Your brokerage will report the amount on a 1099 form at year-end.

Frequently Asked Questions

Can a company skip a preferred dividend to save money?

Not legally, unless the preferred stock is non-cumulative and the company's charter explicitly allows it. Most preferred stock is cumulative, meaning skipped dividends must be paid later before the company can pay common dividends. Skipping a preferred dividend is a serious breach and usually triggers shareholder action or covenant violations in the company's debt agreements.

What is the difference between a preference dividend and a common dividend?

Preferred dividends are fixed, paid first, and contractually may provide. Common dividends are variable, paid only after preferred dividends, and can be cut or eliminated at the board's discretion. Preferred shareholders accept lower upside in exchange for priority and predictability.

Do preference dividends ever increase?

Rarely. Most preferred stock has a fixed rate that never changes. Some preferred stock is "adjustable rate," meaning the dividend rate resets periodically based on a formula tied to interest rates or market conditions. Check your prospectus to see whether your preferred stock is fixed or adjustable.

What happens to unpaid preference dividends if the company goes bankrupt?

Unpaid cumulative preferred dividends become a claim against the company's assets in bankruptcy. Preferred shareholders are paid after creditors and bondholders but before common shareholders. If assets run out, unpaid dividends may be lost entirely, but preferred shareholders still rank ahead of common equity holders.

Can I sell preferred stock that has unpaid dividends?

Yes, but the buyer will typically demand a discount to account for the unpaid dividends owed to them. The accumulated dividend becomes a liability attached to the stock. If the company later pays the back dividends, the new owner receives that payment, not you — so selling at a discount is usually the practical choice.