Every tax year, you expect to pay income taxes on the money you earned throughout the year, but what many taxpayers don’t know is that their dollars may have already been taxed once before. This is called double taxation. Double taxation primarily impacts money earned from corporate revenue and shareholder investments, but there are several other circumstances to be aware of as a savvy taxpayer. In this post, we’ll be discussing what you need to know about double taxation, why it happens, and how you may be able to avoid it. Use the links below to navigate throughout the article, or read all the way through for a more in-depth overview of double taxed income.
- What is Double Taxation? Double Taxation Defined
- How Double Taxation Works
- Who is Subject to Double Taxation?
- Avoiding Double Taxation
- Get Help With Your Business Taxes
What is Double Taxation? Double Taxation DefinedDouble taxation happens when the same source of income is taxed twice in the form of income taxes. This situation is most commonly associated with business revenue, which can be subject to several types of tax, such as profit and dividend tariffs, that could result in double taxation. However, double taxation can also be a side effect of conducting international trade. Now that we’ve defined double taxation, let’s take a closer look at how it actually occurs and who it affects.
How Double Taxation WorksAs we mentioned, double taxation typically impacts business profits which are subject to several types of income tax. Publicly traded corporations, for example, can experience double taxation when their earned income is taxed, and then again when they payout dividends to their shareholders. It’s important to note that while the same source of income is being taxed—the profits of the business—the business isn’t necessarily responsible for remitting the tax both times. In this scenario, the corporation would be liable for paying their owed taxes on profits, but it’s the shareholder’s responsibility to pay capital gains taxes on the dividends that they earned from the company. Put simply, the corporation pays the first round of taxes and the shareholder pays the second round. Though it’s the same money that’s being taxed, if you think about it, both parties are earning income from it, and therefore, must pay income taxes on the amount earned. Another common example of double taxation is money earned on inheritance, which is taxed as income to the original owner, and again when the beneficiaries access the money. It’s important to note that the federal government does not impose an inheritance tax, but several states do. There’s much disagreement on the topic of double taxation, and the tax code has been revised on many occasions to reduce the impact it has on businesses and individual taxpayers, especially when it comes to international double tax. We’ll discuss international tax reform in more detail a little later on in this post.
Who is Subject to Double Taxation?There are a few circumstances where taxpayers may experience double taxation, but it primarily impacts business income relative to corporations and international trade. In this section, we’ll discuss who is subject to double taxation and provide a few examples of why and how this occurs. In order to understand how double taxation happens, it’s important to establish a baseline understanding of how business and corporate taxes are structured. Small businesses are generally considered pass-through entities, wherein business taxes are reflected as part of the business owner’s tax liability. Small business owners file and remit taxes for their business on their own, individual tax return. The revenue earned from a small business is generally not taxed twice, unless they have shareholders to which they pay dividends. Corporations, on the other hand, are subject to corporate income taxes as their own entity, separate from the owners’ tax dues. Corporations file their taxes using a corporate tax return, Form 1120. This form is used to report a domestic corporation’s income, gains, losses, deductions, and credits, and ultimately, to calculate their federal tax liability.
Double Taxation for CorporationsDouble taxed income is most commonly associated with corporate revenue. Remember how we mentioned that corporations file and pay taxes on profits using Form 1120? Here’s where the issue of double taxation comes in. Technically, the money that the corporation earned that tax year has already been taxed, and many believe that that should be where the cycle of taxation ends. But, that’s not always how it works. If a corporation decides to sell shares of the company to investors and pay out dividends at the end of the year, their shareholders will likely pay taxes on the income they earned from their dividends. In other words, the same money that the corporation paid taxes on is taxed again, it’s just a different taxpayer that’s responsible for paying it. The current corporate income tax rate is a flat tax rate of 21%.
Double Taxation for International BusinessesAnother example of double taxation is when international trade is conducted. Let’s use this fictional example of a shoe maker who is based in Spain and sells their product in the United Kingdom. Since the shoe maker is selling their product in their country and earning money from its citizens, the UK decides to collect income taxes from the Spanish shoe company. So, the shoe company complies and pays a certain percentage of their revenue on the income they earned in the UK to the country’s tax bureau. But when the company returns to Spain and brings back the money they earned in the UK to their home country, their profits are taxed a second time by the Spanish government, resulting in double taxation. To avoid the issue of double taxation and prevent international trade sanctions, many countries have signed treaties to stop or minimize the impact of double taxation. This is also known as a tax treaty. Tax treaties must be signed and agreed upon by both countries involved, and many countries abide by the guidelines put forth by the United Nations’ Organization for Economic Co-operation and Development (OECD) Model Tax Convention on Income.
Avoiding Double TaxationPaying double taxes can be frustrating for the corporation and shareholders that hold stake in the company, so many business owners wonder what they can do to avoid double taxation. Luckily, there are a couple of approaches you can take as a business owner to not get double taxed.
- Choose a different business formation
- C-corporations are typically the only business formation that are impacted by double taxation since they are treated as their own entity. Other business types like S-corporations and LLCs are considered pass-through entities. By forming an LLC or other pass-through entity, you can avoid the double tax that C-corporations experience.
- Don’t issue dividends
- Dividends are the main reason that businesses end up having to account for double taxes. To avoid shareholders having to pay tax on their dividends, consider paying salaries instead. Salaries are taxed at the regular personal income tax rate, and can be considered deductible for businesses. Keep in mind, the IRS has to be able to justify the salary, so it’s important to play by the rules outlined by the federal tax code.
- Hire family members
- Another way to avoid double tax is to make family members employees rather than shareholders. As we mentioned, salaries are subject to regular income tax and may be considered deductible for the business. However, the IRS needs to be able to justify the salaries, so it’s imperative that you abide by the tax regulations imposed on corporations.