What Double Taxation Is and How It Works (2024)

What Is Double Taxation?

Double taxation is a tax principle referring to instances where taxes are levied twice on the same source of income. It can occur when income is taxed at both the corporate level and the personal level. Double taxation can also occur in an international trade or investment context when the same income is taxed in two different countries.

Key Takeaways

  • Double taxation refers to income tax being paid twice on the same source of income.
  • This can occur when income is taxed at both the corporate level and the personal level, as in the case of stock dividends.
  • Double taxation also refers to the same income being taxed by two different countries.
  • While critics argue that dividend double taxation is unfair, advocates say that without it, wealthy stockholders could virtually avoid paying any income tax.

How Double Taxation Works

Double taxation often occurs because corporations are considered separate legal entities from their shareholders. As such, corporations pay taxes on their annual earnings, just like individuals. When corporations pay out dividends to shareholders, those dividend payments incur income-tax liabilities for the shareholders who receive them, even though the earnings that provided the cash to pay the dividends were already taxed at the corporate level.

Double taxation is often an unintended consequence of tax legislation. It is generally seen as a negative element of a tax system, and tax authorities attempt to avoid it whenever possible.

Most tax systems attempt, through the use of varying tax rates and tax credits, to have an integrated system where income earned by a corporation and paid out as dividends and income earned directly by an individual is, in the end, taxed at the same rate. For example, in the U.S. dividends meeting certain criteria can be classified as "qualified" and as such, subject to advantaged tax treatment: a tax rate of 0%, 15% or 20%, depending on the individual's tax bracket. The corporate tax rate is 21%, as of 2022.

Debate Over Double Taxation

The concept of double taxation on dividends has prompted significant debate. While some argue that taxing shareholders on their dividends is unfair, because these funds were already taxed at the corporate level, others contend this tax structure is just.

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. Supporters of dividend taxation also point out that dividend payments are voluntary actions by companies and, as such, companies are not required to have their income "double taxed" unless they choose to pay dividends to shareholders.

Certain investments with a flow-through or pass-through structure, such as master limited partnerships, are popular because they avoid the double taxation syndrome.

International Double Taxation

International businesses are often faced with issues of double taxation. Income may be taxed in the country where it is earned, and then taxed again when it is repatriated in the business' home country. In some cases, the total tax rate is so high, it makes international business too expensive to pursue.

To avoid these issues, countries around the world have signed hundreds of treaties for the avoidance of double taxation, often based on models provided by the Organization for Economic Cooperation and Development (IECD). In these treaties, signatory nations agree to limit their taxation of international business in an effort to augment trade between the two countries and avoid double taxation.

How Can I Avoid Double Taxation in Two States?

In some cases, individuals may need to file tax returns in multiple states. This can occur if they work or perform services in a different state from where they reside. Luckily, most states have provisions in their tax codes that can help individuals avoid double taxation. For example, some states have forged reciprocity agreements with others, which streamlines tax withholding rules for employers. Others may provide taxpayers with credits for taxes paid out-of-state, reducing their total obligations and avoiding double taxation. How exactly one can avoid double taxation depends on a wide range of factors, including how income is earned and which states are in question.

What Is the 183-Day Rule?

In the context of state taxes, the 183-day rule refers to a threshold some states use to determine whether or not an individual is a resident for tax purposes. In such cases, a state will consider an individual a full-year resident so long as they spent 183 days or more there.

What States Have No Income Tax?

There are a handful of states that don't levy state income taxes. This includes Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming. However, if residents of these states work or perform services in other states, it's possible that income may still be taxed by those other states.

The Bottom Line

Double taxation occurs when taxes are levied twice on a single source of income. Often, this occurs when dividends are taxed. Like individuals, corporations pay taxes on annual earnings. If these corporations later pay out dividends to shareholders, those shareholders may have to pay income tax on them. Double taxation can also occur when income is taxed by two separate countries. In response to increased globalization giving rise to potential double taxation, many countries have forged tax treaties to avoid taxation and augment trade.

What Double Taxation Is and How It Works (2024)

FAQs

What Double Taxation Is and How It Works? ›

Most commonly, double taxation happens when a company earns a profit in the form of dividends. The company pays the taxes on its annual profits first. Then, after the company pays its dividends to shareholders, shareholders pay a second tax.

What is an example of a double tax? ›

The term "double taxation" can also refer to the taxation of some income or activity twice. For example, corporate profits may be taxed first when earned by the corporation (corporation tax) and again when the profits are distributed to shareholders as a dividend or other distribution (dividend tax).

Do US citizens pay double taxes? ›

The US is one of the few countries that taxes its citizens on their worldwide income, regardless of where they live or earn their income. This means that American expats are potentially subject to double taxation – once by the country where they earn their income, and again by the United States.

Why is double taxation bad? ›

Opponents of double taxation on corporate earnings contend that the practice is both unfair and inefficient, since it treats corporate income differently than other forms of income and encourages companies to finance themselves with debt, which is tax deductible, and to retain profits rather than pass them on to ...

Is double taxation illegal in the US? ›

Contrary to popular belief, there's nothing in the U.S. Constitution or federal law that prohibits multiple states from collecting tax on the same income. Although many states provide tax credits to prevent double taxation, those credits are sometimes unavailable.

How do you avoid double taxation? ›

How to Avoid Double Taxation
  1. Retaining corporate earnings. You can avoid double taxation by keeping profits in the business rather than distributing it to shareholders as dividends. ...
  2. Pay salaries instead of dividends. You can distribute profit as salaries or bonuses instead of as dividends. ...
  3. Split income.
Mar 12, 2024

What are the benefits of double taxation? ›

Benefits of the double taxation treaty

For international businesses, a double taxation treaty helps reduce additional tax burdens. Without this type of treaty in place, income could be taxed both in the country of earnings as well as after it's been repatriated to the home country.

What income is taxed twice? ›

Double taxation occurs when taxes are levied twice on a single source of income. Often, this occurs when dividends are taxed. Like individuals, corporations pay taxes on annual earnings. If these corporations later pay out dividends to shareholders, those shareholders may have to pay income tax on them.

Who pays double taxation? ›

Most commonly, double taxation happens when a company earns a profit in the form of dividends. The company pays the taxes on its annual profits first. Then, after the company pays its dividends to shareholders, shareholders pay a second tax.

What is an example of double taxation in the US? ›

Examples of Double Taxation

The United States' tax code places a double-tax on corporate income with one tax at the corporate level through the corporate income tax and a second tax at the individual level through the individual income tax on dividends and capital gains.

Why is social security taxed twice? ›

The Introduction of Taxes on Benefits

The rationalization for taxing Social Security benefits was based on how the program was funded. Employees paid in half of the payroll tax from after-tax dollars and employers paid in the other half (but could deduct that as a business expense).

Do business owners get taxed twice? ›

The double taxation policy requires businesses to pay their taxes twice on the same income. This policy will often apply to startups structured as corporations, international trades or investments, and traditional IRAs. Luckily, LLCs who want to avoid double taxation can adopt various strategies to work around it.

Do capital gains get taxed twice? ›

The taxation of capital gains places a double tax on corporate income. Before shareholders face taxes, the business first faces the corporate income tax.

Which business avoids double taxation? ›

On the special type of corporation of interest to small businesses is the Subchapter S corporation. This type of corporation avoids double taxation by having its income taxed to the shareholders as if the corporation were a partnership.

Can you opt out of paying taxes? ›

Yes, you can be exempt from California state deductions when it comes to withholding tax. You'll need to complete a DE-4 or W-4 form and also confirm that you won't owe any taxes for the current financial year, nor were you liable for any taxes in the preceding year.

Why do US citizens pay taxes abroad? ›

Yes, U.S. citizens have to pay taxes on foreign income if they meet the filing thresholds, which are generally equivalent to the standard deduction for your filing status. You may wonder why U.S. citizens pay taxes on income earned abroad. U.S. taxes are based on citizenship, not country of residence.

Are partnerships double taxed? ›

In other words, the partnership itself is not taxed, but each partner is responsible for reporting their own profits and losses from the business on their individual tax returns. A clear advantage to the partnership taxation method is that the profits in your partnership are only taxed once.

Are sole proprietorships double taxed? ›

Sole proprietorships are not considered tax entities separate from their owners, so owners do not face double taxation.

Are capital gains taxed twice? ›

The taxation of capital gains places a double tax on corporate income. Before shareholders face taxes, the business first faces the corporate income tax.

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