While death and taxes may both be certain, taxation is the only one of the two that can happen twice. If you own a business, the last thing you want is to get taxed on your income more than once. Double taxation occurs when a corporation pays taxes on its profits and then its shareholders pay personal taxes on dividendsor capital gains received from the corporation.
A financial advisorcan answer questions about double taxation and help optimize your financial plan to lower your tax liability.
What Is Double Taxation?
Double taxation happens when income tax gets levied twice on the same income. So if you’re a shareholder or owner of a corporation, then you may face double taxation because your income will come from corporate earnings that were already taxed, and you will also pay taxes on them.
The same happens to individual investors who pay taxes on dividends, which are a share of a corporation’s earnings. Because the corporation has already paid taxes on those same earnings, they can also face double taxation. And, if you have income in a foreign country, you may also get taxed twice for the same income in that country and the U.S., depending on the circ*mstances.
Double taxation can happen in C corporations, where owners or shareholders get taxed separately. Other businesses pass income down to individuals, for them to pay personal tax rates that are levied once.
In 2022, the federal income tax rate on corporate profits was 21%. But as of 2023, the inflation Reduction Act created theCorporate Alternative Minimum Tax (CAMT), which imposes a 15% minimum taxon large corporations. This applies specifically to corporationswith an average annual financial statement income over $1 billion.
Comparatively, the top marginal individual tax rate for 2023 is 37%. So if a corporation pays the 15% CAMT, and that income gets double-taxed, the combined rate for an individual taxpayer in the top bracket could be 52%.
There are two justifications offered for taxing corporate profits twice. First, the tax on corporate profits is seen as justified because businesses organized as corporations are separate legal entities. Second, levying individual taxes on dividends is seen as necessary to keep wealthy shareholders from paying no income taxes on their gains.
The burden of double taxation is common and significant for corporations and shareholders alike. However, it’s not an inevitable outcome by any means. There are several ways business owners can avoid double taxation altogether or reduce taxes in general.
Why Double Taxation Matters
The obvious reason that people debate double taxation is that the same money is being earned once but taxed twice. However, there are two different entities – typically the business and the individual – that are earning the same money separately. Many argue that the tax structure is just because the individual is earning money from the business entity and the business entity is earning money from its customer.
So, technically, while the money is being taxed twice it is only being taxed when it is earned by a new person or entity. Without double taxation, many argue, that individuals could own large amounts of stock in corporations and live off of their dividends without ever paying taxes on what they are individually earning. Corporations can avoid double taxation by electing not to pay dividends.
Strategies for Avoiding Corporate Double Taxation
As referenced earlier, C corporations are uniquely the only business type that experience double taxation. While the corporation pays taxes once itself, double taxation happens when dividends paid to shareholders get taxed at the shareholders’ individual rates after they’ve already been taxed at the corporate level.
One way to ensure that business profits are only taxed once is to organize the business as a “flow-through” or “pass-through” entity. When a business is organized as a pass-through entity, profits flow directly to the owner or owners. In turn, these are not taxed at the corporate level and again at the personal level. Instead, the owners will pay taxes at their personal rate, but double taxation is avoided.
Some examples of pass-through business entities that can adopt this strategy include:
- Sole proprietorships
- Partnerships
- Limited liability companies (LLCs)
- S corporations
Owners of C corporations who wish to reduce or avoid double taxation have several strategies they can follow, which include:
- Retain earnings: If the corporation doesn’t distribute earnings as dividends to shareholders, earnings are only taxed once, at the corporate rate.
- Pay salaries instead of dividends: Shareholders who work for the corporation may be paid higher salaries instead of dividends. Salaries are taxed at the personal rate but are deductible expenses for the corporation. Salaries have to be justifiable to the IRS, however.
- Employ family: Family members can receive salaries for working for the business. This is another way to take money from the corporation without the corporation having to pay taxes on it first. The same restrictions about justification apply to family employee salaries.
- Borrow from the business: If a corporation owner takes a loan from the corporation, it’s not treated as a taxable dividend. The IRS may inspect the transaction to ensure that the loan is not a disguised dividend, however. For instance, this may require that the loan is being paid back at a reasonable interest rate.
- Set up a separate flow-through business: By using this process, you can use this second businessto lease equipment or property to the C corporation. A business owner can create an LLC that purchases equipment and leases it back to the corporation. This creates flow-through income for the LLC and a deduction for the corporation.
- Elect S corporation tax status: Once a corporation has been created, the owners can ask the IRS to treat it as an S corporation for tax purposes. S corporations have the same liability-limiting attractions as C corporations, but their profits flow directly to shareholders, avoiding double taxation. S corporations are restricted as to the number and type of shareholders and classes of stock, however. So, an S corporation election may not be an option for all corporations.
Double Taxation for International Businesses
Businesses that invest and do business internationally may also experience double taxation. This can happen when profits generated in one country are taxed there and then again by their home country.
Again, this sort of double taxation doesn’t have to happen. Many countries have signed mutual treaties and instituted tax credits to limit this sort of double taxation in the interest of stimulating international investment and trade.
How to Determine If You’ll Need to Pay Double Taxes
CEOs and members of the board of directors of a business can personally choose not to pay taxes on any dividends they receive. Instead, the business will pay its corporate tax, leaving those gains tax-free for them. In addition, you can also use the strategies above to minimize taxes or change the structure of your business altogether to ensure profits go right to ownership.
If you’re an employee of a business where you may encounter double taxes on your dividends, there are some planning steps you can take ahead of time. In general, these benefits can be earned by not selling your holdings for a specific amount of time, leaving you with a more favorable tax rate. By meeting these requirements, your holdings will garner the title of “qualified.” You can generally reach qualified status for dividends by holding them for at least 60 days of the 121-day period that starts 60 days past their specificex-dividend date.
The rules surrounding dividend taxes can get quite complex. You may want to speak with a financial advisor or tax professional before making any final decisions.
Bottom Line
Tax planning should be an integral part of your business strategy. That goes for pass-through entities and C corporations. Taking a strategic approach to your business structure – who you employ, the extent to which you lease equipment or space and compensation, including dividends – can result in a substantial boost to the profit of your business.
- Consider talking to a financial advisor about your small business and double taxation.Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Are you potentially looking to sell your small business? If so, check out SmartAsset’s guide to the taxes surrounding a small business sale.
Photo credit: ©iStock.com/ronstik, ©iStock.com/DNY59, ©iStock.com/Rick_Jo
Mark Henricks Mark Henricks has reported on personal finance, investing, retirement, entrepreneurship and other topics for more than 30 years. His freelance byline has appeared on CNBC.com and in The Wall Street Journal, The New York Times, The Washington Post, Kiplinger’s Personal Finance and other leading publications. Mark has written books including, “Not Just A Living: The Complete Guide to Creating a Business That Gives You A Life.” His favorite reporting is the kind that helps ordinary people increase their personal wealth and life satisfaction. A graduate of the University of Texas journalism program, he lives in Austin, Texas. In his spare time he enjoys reading, volunteering, performing in an acoustic music duo, whitewater kayaking, wilderness backpacking and competing in triathlons.
FAQs
Double taxation happens when income tax gets levied twice on the same income. So if you're a shareholder or owner of a corporation, then you may face double taxation because your income will come from corporate earnings that were already taxed, and you will also pay taxes on them.
What is that double taxation? ›
Double taxation refers to the act of paying income taxes twice on the same income. It can occur in three scenarios, explained below: Income from corporations taxed for the corporation and its members. International investment or international trade.
What is double taxation quizlet? ›
Double taxation means that the: corporation pays taxes on its earnings and the shareholders pay taxes on the dividends received from the corporation.
How can a US citizen avoid double taxation? ›
Foreign Tax Credit
Well, if you qualify for the Foreign Tax Credit, the IRS will give you a tax credit equal to at least part of the taxes you paid to a foreign government. In many cases, they will credit you the entire amount you paid in foreign income taxes, removing any possibility of US double taxation.
What is double taxation for dummies? ›
Double taxation refers to income tax being levied twice on the same income. It most commonly applies to corporations and their shareholders. The corporation is taxed on its earnings or profits, then the shareholders are taxed again on dividends and capital gains they receive from those earnings.
What is an example of double taxation quizlet? ›
Double taxation applies to corporations because earnings are taxed both at the corporate level and the shareholder level when earnings are distributed in the form of dividends. For example, assume JCL, Inc. had taxable income of $100,000 and distributed $50,000 of the earnings to the shareholders as dividends.
What is double taxation in USA? ›
Double taxation refers to the imposition of taxes on the same income, assets or financial transaction at two different points of time. Double taxation can be economic, which refers to the taxing of shareholder dividends after taxation as corporate earnings.
Why is double taxation important? ›
Reason to Permit Double Taxation
One common reason for double taxation is because companies and their shareholders are different. For instance, a company's income is taxed once, but when shareholders receive dividends, this income is taxed again.
What is an example sentence for double taxation? ›
Double taxation Sentence Examples
He tried to compel the Dutch and French refugees in England to unite with the Church of England, advising double taxation and other forms of persecution. A lack of interstate cumity, and double taxation of certain classes of property, have also offered difficulties.
What is double taxation a disadvantage of quizlet? ›
Double taxation is a disadvantage of a corporation because the corporation has to pay income taxes at twice the rate applied to partnerships.
Mostly double taxation refers to the profits of established corporations who often contribute a share of their income towards their shareholder's dividends. If you're both a shareholder and an employee of a business, then both your salary and your dividends are subject to being taxed on your personal income return.
Which type of income is subject to double taxation quizlet? ›
Corporate profits can be subject to double taxation.
How can I avoid taxes legally in the US? ›
You can legally avoid paying taxes on some or all of your income by:
- Taking advantage of a self-employment tax deduction scheme.
- Deducting business expenses from your gross income on your tax return.
- Contributing to a retirement plan and a Health Savings Account (HSA).
- Donating to charity.
- Claiming child tax credits.
Two business structures are often preferred for small businesses since they avoid this double taxation burden. These are an LLC and S Corporation. With these business structures, the company is taxed more like a Sole Proprietorship or a Partnership than as a separate entity, like the C Corporation.
What is one disadvantage of what is double taxation? ›
Cons of double taxation:
Income is taxed twice. Shareholders pay taxes a second time on dividends.
Why is Social Security taxed twice? ›
It's not double taxation because the funds you collect don't come directly from your taxes. Your taxes are paying for today's beneficiaries, so the benefits you receive will be from someone else's payroll taxes. You have to think about your payroll taxes as a premium into a retirement account.
Are capital gains taxed twice? ›
But are those capital gains taxed twice? It depends. When it comes to traditional asset investments (such as stocks), proceeds from the sale can be taxed twice, once at the corporate level and again at the personal level. Then there are capital gains at the state level.
Which scenario is an accurate example of double taxation? ›
Double taxation is experienced by corporations that pay dividends. Which scenario is an accurate example of double taxation? If Cyber Stellar Inc. distributes 20% of its net profit after taxes to its stockholders, these funds will be taxed again, when each individual stockholder claims his/her portion as earnings.
What is an example of double non taxation? ›
As, for example, neither Austria nor Germany levy an income tax on lottery winnings, a German citizen who wins in the Austrian lottery does not have to pay taxes in either state.
Which legal structure has double taxation? ›
A c-corporation is subject to corporate income tax on any corporate profits (entity pays taxes). Shareholders pay personal income tax on the corporate profits distributed by the corporation to the owners. As a result, C-corps are subject to “double taxation.”
Unlike C corporations, LLCs and sole proprietors are legally considered pass-through entities. The structure means their earnings go directly to their owners, who pay their taxes through their personal income tax. Another way you can avoid double taxation is by adopting the S corporation structure.
How can a company avoid paying taxes on profits? ›
How do profitable corporations get away with paying no U.S. income tax? Their most lucrative (and perfectly legal) tax avoidance strategies include accelerated depreciation, the offshoring of profits, generous deductions for appreciated employee stock options, and tax credits.
Is double taxation good or bad? ›
The current tax system taxes corporate income twice. This double taxation has a pronounced negative economic impact, particularly on wages. It distorts the economy and harms productivity. The double taxation of corporate income is also inconsistent with competing concepts of proper income taxation.
What is an example of taxation? ›
Estate and Inheritance Taxes. Fines, Fees, and Forfeitures. General Sales Taxes and Gross Receipts Taxes. Health and Hospital Expenditures. Higher Education Expenditures.
What is an example sentence for double? ›
I'll have a double espresso, please. a double dose of medicine a double order of fries Verb We all doubled over laughing. He doubled up in pain. Adverb raced to his side double quick Noun I'll have one more glass of vodka.
What would eliminating double taxation do? ›
Reduced Saving and Investment
This minimum required return is the cost of capital. A higher tax rate on both corporate income and investment income increases the cost of capital. All things being equal, a higher cost of capital makes it less likely that corporations will invest in projects.
Which type of US firms has the disadvantage of double taxation? ›
C-Corporation
The largest drawback is potential double taxation. A C-Corporation is a separate taxpayer and pays its own taxes.
What is an example of C Corp double taxation? ›
Double taxation
This means a C corporation pays corporate income tax on its income, after offsetting income with losses, deductions, and credits. A corporation pays its shareholders dividends from its after-tax income. The shareholders then pay personal income taxes on the dividends.
What is meant by the phrase double taxation of corporate income? ›
[LO1] What is meant by the term double taxation of corporate income? The term double taxation refers to the fact that under the U.S. system of taxation, corporate earnings are first taxed when earned by a C corporation and then are taxed a. second time when the earnings are distributed to the shareholders as a dividend ...
What is meant by the term double taxation as applied to the corporate form of business organization quizlet? ›
What is meant by the term "double taxation" as applied to the corporate form of business organization? Corporate income is taxed, and then corporate dividends are taxed as well.
Unlike sole proprietors, partnerships, and LLCs, corporations pay income tax on their profits. In some cases, corporate profits are taxed twice — first, when the company makes a profit, and again when dividends are paid to shareholders on their personal tax returns.
What type of tax in which the tax rate stays the same over all incomes? ›
Proportional tax, also referred to as a flat tax, affects low-, middle-, and high-income earners relatively equally. They all pay the same tax rate, regardless of income.
Which type of tax stays the same regardless of income? ›
Flat tax. Flat taxes are when everyone pays the same amount, regardless of income. Flat taxes are typically a flat rate rather than a flat dollar amount.
How do I avoid taxes on a large sum of money? ›
Strategies to Minimize Taxes on a Lump-Sum Payment
- Tax-Loss Harvesting. Tax-loss harvesting allows you to lock in investment losses for the express purpose of lowering your taxable income. ...
- Deductions and Credits. ...
- Donate To Charity. ...
- Open a Charitable Lead Annuity Trust. ...
- Use a Separately Managed Account.
Property taxes are generally considered to be more efficient than other (particularly income) taxes, in part because they are not believed to discourage work, saving, and investing, and they are harder to evade than most other taxes, primarily because of the immobility of property.
Do US citizens legally have to pay taxes? ›
The tax law is found in Title 26 of the United States Code. Section 6012 of the Code makes clear that only individuals whose income falls below a specified level do not have to file returns. While our tax system is based on self-assessment and reporting, compliance with tax laws is mandatory.
Is there double taxation in USA? ›
Filing Taxes with the IRS While Living in Another Country
United States citizens who work in other countries do not get double taxed if they qualify for the Foreign-Earned Income Exemption. Expats should note that United States taxes are based on citizenship, not the physical location of the taxpayer.
What are disadvantages of double taxation? ›
Disadvantages of the double taxation treaty
Some opponents of double taxation relief treaties argue that it's fair to apply taxes to dividends. Without these capital gains taxes in place, wealthy investors could simply live off of tax-free dividends without contributing to the system.
Do corporations avoid double taxation? ›
Corporate double taxation occurs when tax is paid twice on the same corporate earnings. With the exception of S corporations, double taxation affects both corporations and their shareholders. For example, at the end of the fiscal year, a corporation will pay taxes on its earnings for that year.
Does an LLC have limited liability and avoid double taxation? ›
Avoids Double Taxation
LLCs are the only type of corporation not subject to being taxed twice. In a traditional corporation, the company itself must pay corporate taxes on the income it receives, and the owners, who are shareholders, must pay taxes when they receive dividends of the company.
An LLC is considered a pass-through entity—also called a flow-through entity—which means it pays taxes through an individual income tax code rather than through a corporate tax code. In addition to LLCs, sole proprietorships, S Corporations, and partnerships are all pass-through businesses.
What business is taxed twice a year? ›
Double taxation on corporations
Businesses that are registered as C corps (and LLCs that elect to be treated as corporations) are taxed twice on business profits. The corporation first pays taxes on its profits, but then stockholders must pay personal income taxes on the dividends paid from the company's profits.
Who pays more taxes in US? ›
The highest-earning Americans pay the most in combined federal, state and local taxes, the Tax Foundation noted. As a group, the top quintile — those earning $130,001 or more annually — paid $3.23 trillion in taxes, compared with $142 billion for the bottom quintile, or those earning less than $25,000.
Do US dual citizens pay double taxes? ›
Don't worry — just because you have a U.S. tax filing obligation doesn't mean you'll be double-taxed or subject to dual taxation. The U.S. has a few options designed to ease the tax burden on dual citizens, including tax treaties, the Foreign Tax Credit, and the Foreign Earned Income Exclusion.
Why would you want double taxation? ›
Proponents of double taxation point out that without taxes on dividends, wealthy individuals could enjoy a good living off the dividends they receive from owning large amounts of common stock, yet pay essentially zero taxes on their personal income. Stock ownership could become a tax shelter, in other words.
Who is affected by double taxation? ›
In the United States, corporate income is taxed twice, once at the entity level and once at the shareholder level. Before shareholders pay taxes, the business first faces the corporate income tax.
What type of business firm is double taxation a disadvantage of? ›
Double taxation
The main disadvantage of the C corporation is that it pays tax on its earnings and the shareholders pay tax on dividends, meaning the corporation's earnings are taxed twice.
What is an example of a double tax relief? ›
A double tax agreement effectively overrides the domestic law in both countries. For example, if you are non-resident in the UK and you have UK bank interest, this income would be taxable in the UK as UK-sourced income under domestic law.
