Taxing Stock Dividends and Economic Theory

Since 1936, the Internal Revenue Code has treated elective stock dividends on common stock, which are taxed on receipt as shareholder ordinary income gain, differently from pro rata stock dividends on common, which are received tax-free. This difference in treatment was reenacted in Section 305 of the 1954 Code; and while the Tax Reform Act of 1969 changed many details of stock dividend taxation, the basic distinction between elective and pro rata stock dividends was, if anything, reinforced. The major purpose of the 1969 amendments to Section 305 was to impose a shareholder ordinary income tax on transactions with the same substance, but lacking the formal indicia, of the receipt of elective stock dividends on common stock. Therefore, a reexamination of the rationale for current distinctions between taxable and nontaxable stock dividends is particularly appropriate