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.
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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.
