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What does double taxation mean in simple terms?
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What Is Double Taxation
Double taxation refers to the concept where the same income is taxed twice.
In other words, when a company or individual is required to pay income taxes on the same income, we refer to that as “double taxation”.
For example, c corporations will need to report their income at the end of their fiscal year and pay corporate income taxes on it.
Then, using the net income (income that was already taxed), they can choose to pay dividends to their shareholders.
However, the shareholder receiving dividends from the company’s post-tax money will need to report it on his or her personal income taxes and pay taxes on it (same income being taxed a second time).
Double Taxation Definition
According to the Legal Information Institute, double taxation means:
Double taxation refers to the imposition of taxes on the same income, assets or financial transaction at two different points of time.
As you can see, double taxation refers to the situation when income, an asset, or financial transaction is taxed twice by the taxation authorities.
According to Investopedia, double taxation refers to the following:
Double taxation is a tax principle referring to income taxes paid twice on the same source of income.
In essence, income from the same source is taxed twice.
Double Taxation Definition Economics
Double taxation is economic is when the same income is taxed twice in the context of a particular transaction, setup, or structure, to achieve an economic end result.
For example, corporations are generally subject to double taxation.
When the corporation generates revenues, it will first need to pay taxes on its earnings.
Then, if it chooses to pay dividends to its shareholders using post-taxation earnings (or its net income), the shareholders will be taxed personally on the dividends they receive.
As you can see, the same dollar of income is taxed in the hands of the corporation and individual shareholders.
Double Taxation Definition Legal
Double taxation is legal when the same income is subject to taxes in more than one country.
For example, if a person or individual earns an income in one country, it may have a legal obligation to pay income taxes for the same income in another country.
As a result, different tax laws apply to the same income from a legal perspective.
To minimize the negative consequences of double taxation from a legal perspective, countries have entered into tax treaties where they have agreed to a set of rules and frameworks preventing corporations, international companies, and individuals to be taxed twice for the same income.
Double Taxation Corporation
The concept of double taxation is very often linked to how tax laws apply to corporations.
Since corporations are separate legal entities from their shareholders (or owners), they are generally required to pay their own taxes on the revenues they generate in any given year.
When they pay corporate income taxes on their earnings, their income is essentially taxed for the first time.
Should the company pay out dividends to its shareholders, the shareholders will have to pay taxes on the dividends they received although the same income was already taxed in the hands of the corporation.
This is the second time the same source of income is taxed by the taxation authorities.
There are different types of companies that you may form allowing you to avoid double taxation, like:
- S corporation
- Limited liability company
It’s important to have a good understanding of your tax situation to assess how you should set up your company to avoid double taxation.
Double Taxation Debate
Corporation double taxation has given rise to a lot of criticism over the years.
Critics argue that the government should not tax the same income twice as it is unfair to have the company pay taxes on its annual income and then shareholders have to pay personal taxes when they get dividends (which is the payout of the company’s net income really).
On the other hand, proponents of corporate double taxation say that this type of taxation regime is fair as it forces wealthy individuals to pay their fair share of taxes.
Otherwise, rich individuals can invest significant sums of money on stocks or operate businesses and have little to no taxes to pay on their dividends although they are generating high levels of income.
Another argument that is used to defend double taxation on companies is that shareholders are not taxed for so long as the company does not pay out dividends.
If the company uses its retained earnings to continue doing business, its earnings will not be subject to double taxation.
However, since the company makes a deliberate decision to pay dividends to its shareholders from its profits, then the shareholders should accept to pay income taxes on their dividend earnings.
Double Taxation Example
Let’s look at an example of double taxation to see how it works.
Since the concept of double taxation is generally linked to corporations, let’s use a c-corporation as an example.
Imagine that you have a small business that you operate under a c-corporation.
Imagine that your company earns $300,000 in annual income.
At the end of the year, the company is required to pay $75,000 in corporate income taxes (this is the first time that the company revenues are taxed).
This leaves you a net income of $225,000.
Now, imagine that you want to reinvest $150,000 back into the company and pay yourself $75,000 in dividends.
When you pay yourself $75,000, you will then need to report that on your personal income taxes in the year the dividend was received.
Imagine that on your dividends, you are required to pay $25,000 in taxes leaving you $50,000 in your pocket after taxes.
Essentially, you just paid taxes on the same dollar of company income twice.
As you can see, from your original $300,000, you paid $75,000 in taxes through your company and you paid $25,000 taxes as a shareholder.
Your total tax liability (corporate and personal) on the company’s original income of $300,000 amounts to $100,000.
Double Taxation FAQ
Let’s look at frequently asked questions related to the principle of double taxation.
How to avoid double taxation
Understanding the tax code is very important to find tax strategies allowing you to avoid double taxation.
For individuals that are looking to start a new company, operate a small business, or reduce their tax liability from double taxation, you can consider finding alternative vehicles to operate your business.
For example, c-corporations are taxed under Subchapter C of the Internal Revenue Code and are subject to double taxation.
However, you can also choose to form a corporation and elect that it be taxed under Subchapter S (called an s-corporation) allowing it to pass-through corporate income to its shareholders.
You can also consider forming a partnership that allows partnership revenues to be taxed in the hands of the partners or even form a limited liability company (LLC) allowing you to choose to be taxed like a corporation or partnership.
International companies or individuals earning income internationally should consult tax attorneys and experts to find out how they can avoid double taxation caused by the application of different tax laws to the same income.
The strategies may be more complex but there may be various ways to legally avoid double taxation, such as getting tax exemption from a foreign source of income or credit in foreign income taxes paid.
Is double taxation legal
Double taxation is in fact a legal concept.
There are situations when the government or tax authorities implement measures to specifically tax the same income twice.
This is the case for corporations where the corporation pays income tax on its earnings and when it pays dividends to shareholders using its after-tax money, the shareholders will pay taxes on the dividend income they receive.
In other cases, double taxation is the result of unintended consequences of tax legislation.
In other words, tax legislation is adopted to achieve a certain goal but results in double taxation to certain taxpayers.
When that happens, the governments will try to modify the tax laws, issue tax credits, or try to apply different tax rates to eliminate unintended double taxation.
Double Taxation Meaning Takeaways
So, there you have it folks!
What does double taxation mean?
How do you define double taxation in simple terms?
Is double taxation illegal in the first place?
In essence, “double taxation” is when you are required to pay taxes on the same dollar of income that you have earned either at the company level or individual level.
For example, there are different scenarios that can lead to the same source of income to be taxed a couple of times, such as:
- Income taxed in the hands of c-corporations and the same income taxed in the hands of shareholders as dividends
- International investments or international trade leading to the application of more than one tax laws require you to pay taxes
- Some loans such as 401k loans
The most common form of double taxation that most people are familiar with is when a company earns a profit and pays income taxes and then uses the profits to pay dividends to shareholders who are required to pay taxes on the dividends as well.
If you are looking to start a business or you are already running a business, it’s best to consult a tax professional or financial advisor to consider your options in such a way that you avoid having to pay taxes twice on the same income.
I hope I was able to explain to you what double taxation means, how it works, and why it’s important.
Good luck with your tax planning!
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Understanding Double Taxation
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