Common vs. Preferred: Taking Stock of Ownership

Most private company shareholders know they own shares. Fewer know what those shares actually entitle them to — until a distribution, a liquidity event, or a succession transfer makes the distinction material.

This piece is a practical guide to the differences between common and preferred stock in a private company context: what the rights are, how they interact, and what the tax implications are for shareholders navigating gifted or inherited positions.

• Common stock typically carries voting rights and residual ownership claims, but sits behind preferred stock in liquidation preference — which means common shareholders may receive less than expected in a sale or wind-down scenario.
• Preferred stock often carries a dividend preference, meaning preferred shareholders must receive their distributions before common shareholders receive anything — a distinction that matters significantly in lower-valuation transaction outcomes.
• The tax implications of gifted or inherited preferred shares can differ substantially from common stock, particularly around valuation discounts applicable to minority, non-voting positions.
• Private companies with multi-class equity structures need an administration system that can accurately track each class’s rights, preferences, and positions — and communicate them clearly to shareholders who hold different classes.

Common Stock: The Voice of Ownership

Common stock embodies the epitome of ownership in a private company. Holders of common stock enjoy voting rights, granting them the power to influence corporate decisions, elect board members, and shape the company's direction. This active involvement in shaping the company's future is a hallmark of common stock ownership.

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Moreover, common stockholders stand to reap the rewards of a company's success. As the company's profits grow, common stockholders are entitled to receive dividends, a distribution of a portion of the company's earnings. The prospect of dividend payments incentivizes investors to support the company's growth initiatives.

Risks and Tax Implications of Common Stock

While common stock ownership offers the potential for significant rewards, it also carries inherent risks. In the event of a company's liquidation or bankruptcy, common stockholders are the last in line to receive any remaining assets. This residual claim on assets places common stockholders at a disadvantage compared to other stakeholders, such as creditors and preferred stockholders.

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From a tax perspective, common stock dividends are generally taxed at the ordinary income tax rate. However, if the dividends are classified as qualified dividends, investors may be eligible for lower tax rates.

Cost Basis and Gifting Considerations for Common Stock

The cost basis of common stock refers to the original purchase price of the stock. When common stock is sold, the capital gains or losses are calculated based on the difference between the selling price and the cost basis.

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Gifting common stock can have tax implications for both the donor and the recipient. If the stock has appreciated in value, the donor may be responsible for capital gains taxes on the unrealized gain. The recipient may also owe taxes on the appreciated value of the stock if they sell it within one year of receiving it.

Preferred Stock: A Priority Seat at the Table

Preferred stock, as the name suggests, provides preferential treatment to its holders in comparison to common stockholders. Preferred stockholders enjoy priority rights to dividends, ensuring that they receive their dividend payments before any dividends are distributed to common stockholders. This priority status safeguards their investment and provides a more predictable income stream.

Risks and Tax Implications of Preferred Stock

While preferred stockholders receive preferential treatment in terms of dividends and asset distribution, they typically forgo voting rights. This lack of voting power reflects the priority status granted to preferred stockholders in terms of dividends and asset distribution.

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Dividend payments on preferred stock are generally considered ordinary income for tax purposes. However, some preferred stock dividends may qualify for a deduction for the issuing company, which could reduce the company's overall tax liability.

Cost Basis and Gifting Considerations for Preferred Stock

The cost basis of preferred stock is determined in the same manner as common stock. However, preferred stock is generally more stable in value than common stock, making it less likely to experience significant capital gains or losses.

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Gifting preferred stock can have similar tax implications to gifting common stock. The donor may be responsible for capital gains taxes on the unrealized gain, and the recipient may owe taxes on the appreciated value of the stock if they sell it within one year of receiving it.

Tailoring Equity Structures to Fit Business Objectives

The decision between common stock and preferred stock hinges on the specific needs and objectives of the private business. For companies seeking active investor participation and a strong alignment of interests with management, common stock may be the preferred choice.

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Conversely, companies seeking to raise capital while minimizing the dilution of voting control and mitigating risk for investors may opt for preferred stock. The preferential treatment offered to preferred stockholders provides comfort to investors, making them more willing to invest in riskier ventures.

Empowering Private Businesses Through Equity Management Software

Nth Round recognizes the complexities of equity ownership and the critical role it plays in the success of private businesses. Our equity management software empowers companies to streamline and manage their equity structures effectively, ensuring compliance, transparency, and optimal decision-making.

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With Nth Round, private businesses can:

• Easily track and manage shareholder data
• Issue and manage various types of equity securities
• Generate reports and visualizations for informed decision-making
• Stay transaction-ready and organized

Nth Round is committed to helping private businesses navigate the intricate world of equity ownership, enabling you to make informed decisions that fuel growth and success.

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Disclosure: The information provided in this blog post is intended for informational purposes only and should not be construed as legal, financial, or tax advice. While we strive to provide accurate and up-to-date information, tax laws and regulations are subject to change, and the application of tax laws can vary depending on individual circumstances. This blog post does not constitute professional advice, and it is recommended that you consult with a qualified tax professional, accountant, or financial advisor for personalized guidance regarding your specific tax situation. Always rely on the advice of a qualified professional who is aware of your unique circumstances and can provide advice tailored to your needs.

Can a private company have both common and preferred stock simultaneously?

Yes, and many do. Private companies issue multiple share classes for a variety of reasons: to distinguish between founders and investors, to provide different economics to different shareholder groups, to facilitate estate planning strategies, or to structure governance in a way that separates voting control from economic ownership. Each class has its own rights and preferences, and the company’s cap table and administration system must track each class separately to accurately reflect what each shareholder holds.

How do dividend distributions differ between common and preferred shareholders?

Preferred shareholders typically receive dividends before common shareholders — this is the “preference” that gives preferred stock its name. In a company that distributes regularly, preferred shareholders receive their defined amount first; common shareholders receive what remains. In a company that doesn’t distribute regularly, accumulated preferred dividends may need to be paid before common shareholders see any distribution in a transaction.

What are the tax implications when preferred shares are gifted to the next generation?

Gifted shares generally carry over the donor’s cost basis to the recipient — the basis doesn’t reset to the value at the time of the gift. For preferred shares with liquidation preferences or dividend features, the valuation for gift tax purposes may be different from common stock, and valuation discounts for minority or non-voting interests may apply. The interaction between the carryover basis rules, applicable valuation discounts, and the share class features makes gifted preferred stock one of the more technically complex areas of family business equity planning.