Double TaxationIncome taxes applied twice to the same source of income

Benjamin Franklin once said, “in this world, nothing can be said to be certain, except death and taxes”.

Indeed, taxes have been a mainstay for as long as we know, albeit with some changes here and there from how they once were.

In the US specifically, taxes have been around even before the establishment of the federal government.

As of now, taxes still exist.

Corporations, especially, carry different tax rules and responsibilities than the other business structure such as sole proprietorship, partnership, etc.

For example, corporations follow a different tax rate for income taxes.

Aside from that, corporations can also be subject to double taxation, particularly in the dividends that they declare and distribute.

This isn’t the only instance where double taxation applies though.

And that’s why in this article, we will be exploring what double taxation is.

We will define what it is and identify how it works.

We will also identify the situations in which it applies.

What is Double Taxation?

Usually, a taxpayer will only pay income taxes once for each source of income.

However, there are some instances where income taxes are imposed twice for the same source of income.

This is what we refer to as double taxation (for when you pay income taxes twice on the same source of income).

Double taxation typically applies to corporations.

It occurs when income is taxed at both the corporate level (corporate tax) and personal level (individual tax), hence, double taxation.

The business structures where double taxation applies include the following:

• C Corporations; and
• LLCs that elect to be treated as corporations

Business structures other than those mentioned above manage to avoid double taxation because of their pass-through entity status.

This means that the business doesn’t pay taxes on a corporate level.

Rather, any income it earns is passed to its owner/s.

The income is then taxed at the personal level.

Thus, the income is only taxed once.

Double taxation can also occur on international trades or investments. It occurs when two different countries impose taxes on the same income.

For example, let’s say that a non-US citizen earns income in the US.

This non-US citizen pays income taxes in the US for the income s/he earns.

S/he also pays income taxes in his/her country of origin for the same source of income.

In this case, there is double taxation. In most cases though, countries have signed treaties that prevent this instance of double taxation.

Another situation where double taxation may apply has something to do with qualified deferred compensation plans.

In 2022, the IRS imposes a limit of $20,500 for qualified deferred compensation.

Any contribution beyond this limit risks exposure to double taxation. To avoid double taxation, any excess contribution should be returned to the employee before the tax deadline.

How Double Taxation Works

Corporations are separate legal entities from their owners (shareholders).

Thus, we can say that the income corporations are technically separate from the income their shareholders earn.

Corporations also pay taxes on any income that they earn.

Because of this separation of identity, double taxation occurs.

Particularly, double taxation occurs when the corporation declares and eventually distributes dividends to its shareholders.

When a shareholder receives dividends, s/he incurs a tax liability.

Even though the corporation has paid for the related income taxes for the source of the dividends, the shareholder still has to pay taxes on it (which is the same source).

Thus, there is double taxation.

Most see double taxation as an unintended consequence of tax legislation.

Tax authorities would want to avoid it whenever possible. For example, the lowest rate for dividend tax is 0%.

Double taxation also occurs when two different countries impose taxes on the same income.

For example, in the US, a nonresident alien has to pay income taxes on any income that s/he earns in the US.

The same nonresident alien may also have to pay income taxes on any income s/he earns regardless of source.

This can result in double taxation if the nonresident alien earns income in the US.

To avoid this instance of double taxation, many countries have signed treaties that prevent it.

Lastly, double taxation may occur when the contribution of an employee to a qualified deferred compensation plan exceeds the limit of $20,500 set by the IRS.

What happens is that employees pay income taxes for any exceeding the limit.

S/he also has to pay taxes when s/he finally receives the deferred compensation, hence, double taxation.

To avoid this instance of double taxation, the excess amount must be returned to the employee on or before the deadline for income taxes.

Arguments Regarding Double Taxation

Most often see double taxation as a negative outcome of tax legislation.

Why should shareholders have to pay taxes on dividends when the corporation has already paid the taxes for their source?

Others argue that it’s unjust, while others argue that it’s only right.

Corporations are separate legal entities from their shareholders after all.

Besides, double taxation only occurs when a corporation declares and distributes dividends.

If there are no dividends, there are also no dividend taxes.

Those who are in favor of double taxation argue that not taxing dividends may result in a wealthy individual not having to pay any income taxes at all.

Suppose that this wealthy individual’s income solely comes from the dividends s/he receives from the many investments s/he has in many corporations.

Without taxes on dividends, this wealthy individual won’t have to pay any income taxes even though s/he clearly has income.

And this is on top of the protection that corporations already provide (limited liability).

If an individual wants to avoid double taxation via dividend tax, s/he may want to invest in businesses that have the pass-through entity status such as a sole proprietorship, partnerships, LLCs, or S corporations.

Since these business structures have the pass-through entity status, they don’t pay taxes at the corporate level.

Rather, any income that these businesses earn is included in the taxable income of their owners.

Thus, the income is only taxed once, at the personal level.

This entirely avoids a double taxation situation.