Wouldn't it be better if reinvested dividends were simply treatable as capital gains for tax purposes?
Suppose I own 100 shares in XYZ corp purchased for 25c in year 2000.
If XYZ corp pays me 5c in dividends in year 2001, I will owe tax on the 5c dividends, hopefully as qualified dividends(?).
If on the other hand, they keep holding the cash, I will not owe any tax, and hopefully I am able to sell my share for 5c more since the company has that much extra cash tied up in its coffers. Which would make it a 5c capital gain, right?
Where things get confusing: what if they have a dividend reinvestment plan? To my naiive point of view, it seems like if all my dividends are reinvested, basically it should be the equivalent of the company having kept the cash, and I should simply be able to treat this as a capital gain when I sell all my shares (100 + X from reinvestment).
So one question - is that really a valid argument according to the U.S. tax code? I think the answer is no, since I've seen advice to the contrary.
But really, my main question is - wouldn't it be much simpler for everybody (taxpayers, IRS) if dividend reinvestment could be treated this way? Why on earth go to the trouble of calculating basis for every single dividend reinvestment (as I have seen advised to do)?
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Your intuition is incorrect for two reasons. First, from a tax point of view, reinvestment of dividends are treated as if you got the cash and bought more of the stock yourself. This is true even if the dividends are reinvested for you and you never see the cash. Second, reinvesting the dividends is not the same as the company keeping the cash. If they keep the cash, it is on its books as an asset. If they give the cash to you and you buy more stocks, the seller of the stocks you bought, not the company, gets your cash.
As for why it is this way, it is hard to say. The tax code wasn't created all at once. It has accreted over the past century, being added to through compromises of many different factions each with their own agendas and interests.
Is that valid Argument? NO
And here is why
Lets say you have DRIP(Dividend Reinvestment plan), that means you are buying more shares of the same equity with dividend(cash), but on this cash(got as qualified dividends) you would have to pay tax yearly.
When you sell all your shares of this equity, you would have many different buckets of shares with different purchase costs and so your capital gains are calculated based on these different costs. So you are not paying any double tax.
If you do not like dividend payout, purchase companies who never pay dividends. Then, all your "income" will come from capital gains. Companies also sometimes issue "stock dividends", which is a non taxable event for the shareholder.
From point of the view of the IRS, you're just buying more stock every quarter. There's nothing special about that, and thus you must follow all of the rules with such transaction, including annoyances such as possible future wash sales.
What do you propose the IRS (and all the state tax authorities) do? Somehow separating people who reinvest and who receive cash will be more of a hassle, in my opinion. All recent cost basis are reported to the IRS anyway, so it's not much trouble keeping track.
For the other part of your question, keep in mind some investor do like receiving dividends and do not necessarily reinvest them, but use them for their living expenses (or any expense).
Also, when the share price of company xyz goes down by 40% during a recession, their dividend payout will not necessarily decrease by 40%. This is a reason why some people like to hold onto dividend paying stocks, because their stream of income is more stable.
Lastly, fundamentally many people value a stock by their discounted cash flows, so we expect the company to eventually pay dividends (or go bankrupt and pay out the leftovers).
TLDR;
Dividends are dividends, and DRIPs are there for your convenience. They do not change the characteristic of your transaction, so the IRS will treat it the same, as a stock purchase.
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