What is Double Taxation?

How Does Double Taxation Work?

Double taxation refers to how corporations and their shareholders are taxed twice on earnings. Shareholders of corporations, including individual investors and corporate executives, pay taxes on dividends they receive—representing a share of the corporation's earnings—after the corporation has already paid tax on its profits or earnings. It can also refer to a company or individual being taxed by two different countries on the same income.

Most small corporations and new corporations don't pay dividends. They retain their earnings, putting the money back into the company for growth rather than paying any portion out to shareholders. Older, more established corporations have slower growth, and they pay some of their incomes as dividends to shareholders.

Another description of double taxation applies to shareholders who are also employees of the corporation. They might be paid a salary, which is taxable on their personal income tax returns, and receive dividends, which are also taxable on their personal returns. In both cases, they're being paid from the corporation's taxed earnings.

Ordinary dividends then are taxed at the individual owner's tax rate as well, which can be as much as 37% in the 2022 tax year on incomes over $539,900 for single taxpayers or $647,850 for married taxpayers who file jointly. In tax year 2023, the 37% tax rate applies to incomes over $578,125 and $693,750, respectively.

As an example, say a company realizes profits of $1 million. It retains earnings of $500,000 and pays $500,000 in dividends to its shareholders. Joe is a shareholder and he receives $10,000 in dividends. The company paid a 21% tax at the corporate tax rate on the $1 million, and Joe must additionally pay tax on the $10,000 as income at his own personal tax rate.

A corporate owner might receive salary or wages as an employee, and this salary is also taxed at the individual's regular personal income tax rate. The owner is also a shareholder and must also pay a tax on dividends received. Most dividends are also taxed at the shareholder's personal tax rate.

Corporations vs. Other Business Structures

Only C corporations have to deal with double taxation. Other types of businesses don't typically have this problem.

S corporations are taxed like a partnership. Their profits are passed down to their owners, who are taxed on their individual income tax returns.

LLCs, partnerships, and sole proprietorships are "pass-through" entities as well. Business income is passed through to their owners, who pay taxes on their individual income tax returns. The owners of these businesses are taxed directly, unlike a corporation that pays its own taxes separately from owners.

Partnerships and multiple-member LLCs that are taxed as partnerships must file partnership tax returns, but this is only an informational return. It simply reports the net income of the business to the IRS, and this net income is passed through to the owners and should appear as taxable income on their returns.

Sole proprietors and single-member LLCs file their business tax reports on Schedule C, and the income is included in their owner's personal returns.

International Double Taxation

Companies that operate internationally may face double taxation if their earnings are taxed in the country where it's earned, then taxed again when the money is brought back to the home country. But often, the taxes can be avoided. Countries around the world have signed numerous treaties in which signers agree to limit corporate taxes so that companies aren't taxed twice.

U.S. citizens and permanent residents who live overseas also often must pay income taxes in the country where they're living and the U.S. The foreign earned income exclusion lets expatriates exclude $112,000 of foreign earnings from income in the 2022 tax year and $120,000 in tax year 2023. And the foreign tax credit lets you claim a credit for foreign taxes you've paid on your income. You can claim the foreign tax credit only on income that was not excluded using the foreign earned income exclusion.

Can I Avoid Double Taxation?

There's no dodging taxation if you receive dividends, but buying and holding stocks long enough to meet the rules for qualified dividends can at least give you a lower tax rate on this income, in many cases. You'll still pay tax on this income after the corporation has already done so, but the rate will be more favorable.

If you structure your corporation as something other than a C corporation so that the tax on the net income of the business is passed through to the owners, you can avoid double taxation.

And if you are an American or resident alien living in another country, you can use the foreign earned income exclusion and foreign tax credit to avoid double taxation.

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