What Is Meant by the Term Double Taxation?

Double taxation refers to the situation where the same income is taxed more than once. This arises because various taxing authorities, whether different levels of government within a country or different countries, assert their right to tax the same economic activity or income stream. This phenomenon highlights how income can be subject to multiple layers of taxation before it fully reaches the ultimate recipient.

Double Taxation on Corporate Profits

Corporate profits can experience double taxation when a business is structured as a C-corporation. This occurs because the corporation is treated as a separate legal entity from its owners for tax purposes. Profits are taxed first at the corporate level, and then again when those after-tax profits are distributed to shareholders.

The first layer of taxation involves the corporation paying income tax on its earnings. For federal purposes, C-corporations are subject to a flat corporate income tax rate of 21% on their taxable income. After the corporation pays its income tax, any remaining profits can be distributed to shareholders as dividends.

The second layer of taxation occurs when shareholders receive these dividends, which are subject to individual income tax. The tax rate depends on whether they are classified as “qualified” or “ordinary.” Qualified dividends are taxed at preferential long-term capital gains rates (0%, 15%, or 20%), depending on the shareholder’s income bracket. Ordinary dividends are taxed at the shareholder’s regular income tax rates (10% to 37%).

Another scenario leading to the second layer of taxation involves capital gains when shareholders sell their stock. If a company retains earnings instead of distributing them as dividends, its stock value may increase. When shareholders sell shares at a profit, this gain is subject to individual capital gains tax. Long-term capital gains (assets held over one year) are taxed at the same preferential rates as qualified dividends (0%, 15%, or 20%). Short-term capital gains (assets held one year or less) are taxed at ordinary income tax rates.

In contrast, pass-through entities, such as S-corporations, partnerships, and Limited Liability Companies (LLCs), avoid corporate double taxation. These business structures are designed so that profits are not taxed at the entity level. Instead, income “passes through” directly to the owners’ personal tax returns, taxed only once at their individual income tax rates. This means income from these entities is subject to a single layer of taxation, making them a common alternative to C-corporations.

Double Taxation on International Income

Income earned across national borders can also face double taxation, arising when both the country where the income originates (the source country) and the country where the recipient resides (the residence country) assert their right to tax the same income. This can apply to various types of income, including foreign-sourced dividends, interest, royalties, or business profits. For example, a U.S. citizen earning investment income in a foreign country might find that income taxed by the foreign government and then again by the U.S. government.

To address this issue, tax systems and international agreements employ specific mechanisms to prevent or reduce international double taxation. One primary mechanism is the Foreign Tax Credit (FTC). The FTC allows U.S. citizens and resident aliens to reduce their U.S. tax liability by the amount of income taxes paid to a foreign government on the same income. This credit provides a dollar-for-dollar reduction in U.S. tax, up to the amount of U.S. tax owed on that foreign income. Taxpayers calculate and claim this credit using IRS Form 1116.

Another important tool in mitigating international double taxation is tax treaties. These bilateral agreements between two countries aim to clarify taxing rights and prevent income from being taxed by both jurisdictions. Tax treaties define which country has the primary right to tax specific types of income, such as business profits, dividends, interest, and royalties. They reduce or eliminate withholding tax rates on certain types of cross-border income, making international transactions more efficient. Treaties also establish mechanisms for resolving disputes between tax authorities, providing greater certainty for international taxpayers.