What is Double Taxation?

Definition and Examples of Double Taxation

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The term "double taxation" describes how taxes on what seems like the same income are imposed on two parties. It most commonly applies to corporate shareholders and their corporations. The corporation is taxed on its earnings or profits, then the shareholders are taxed again on dividends they receive from those earnings.

Corporate shareholders often complain that they're being "double taxed" because of this system. It predominantly occurs with larger, older corporations.

What Is Double Taxation? 

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.

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 and owners 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.

How Does Double Taxation Work?

Corporations are taxed at a corporate rate of 21% as of the 2020 tax year. This is down from 35% in 2017, thanks to the Tax Cuts and Jobs Act.

Ordinary dividends are then taxed at the individual owner's tax rate as well, which can be as much as 37% in the 2020 tax year on incomes over $518,400 for single taxpayers or $622,050 for married taxpayers who file jointly.

Dividends held for a longer time are considered "qualified" according to IRS rules, and they can be taxed at the lower capital gains tax rate of 15% if the owner has income of less than $434,400 as of the 2019 tax year, the return you'd file in 2020.

As an example, say ABC Corporation 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. ABC Corporation 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 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 and are taxed on their individual income tax returns. 

LLC's, partnerships, and sole proprietors 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. 

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. 

C Corporations Other Business Types
Pay taxes as a business  Do not pay taxes as a business
Might pay a percentage of profits to shareholders as dividends  Profits trickle down through the corporation to be paid by owners on their own personal returns
Shareholders pay taxes a second time on dividends Owners pay tax only once when the income passes through to them

Do I Need to Pay Twice?

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. You'll still pay tax a second time after the corporation has already done so, but the rate will be more favorable.

Most dividends are considered to be qualified if you hold or own them for more than 60 days of a 121-day period that begins 60 days before the ex-dividend date. A tax professional can explain to you how to qualify.

You also have the option to elect not to pay dividends if you're on the board of directors or you're the CEO of a corporation. Let the corporation pay the tax on business income.

Another way to avoid double taxation is to structure your corporation as something other than a corporation so that the tax on the net income of the business is passed through to the owners.

Key Takeaways

  • Double taxation occurs when a corporation pays the corporate tax rate on earnings or profits, then pays dividends from those profits to shareholders who are again taxed on the money at their personal rates.
  • Double taxation can also occur when a shareholder or owner works for the corporation and draws a salary or wages from corporate earnings that they must also pay taxes on.
  • Double taxation is somewhat unique to C corporations. Most other business entities pass their income down to their owners to be taxed once at owners’ personal tax rates.

Note: The decision of which business type to use is one you should discuss with your advisors. Every business is unique and the tax rules change frequently.

 

Article Sources

  1. Digital Media Law Project. "Double Taxation." Accessed July 24, 2020.

  2. Tax Policy Center. "How Does the Corporate Income Tax Work?" Accessed July 24, 2020.

  3. Tax Foundation. "2020 Tax Brackets." Accessed July 24, 2020.

  4. IRS. "Topic No. 409 Capital Gains and Losses." Accessed July 24, 2020.

  5. Tax Policy Center. "What Are Pass-Through Businesses?" Accessed July 24, 2020.

  6. IRS. "Publication 550 Investment Income and Expenses." Page 19. Accessed July 25, 2020.