What is double taxation: How it works & ways to avoid it

In the world of taxation, one term that often causes confusion and concern is "double taxation".

This concept, while seemingly straightforward, can have significant implications for both individuals and businesses, particularly those operating across international borders.

In this article, we will delve into what double taxation is, how it works, and explore some strategies to avoid it.

What is double taxation?

Double taxation refers to the phenomenon where the same income is taxed twice. This can occur in two main scenarios:

1. when income is taxed at both the corporate and personal level,
2. when the same income is taxed in two different countries.

How double taxation works

Double taxation typically occurs in one of two ways.

1. The first is through corporate income being taxed twice. This happens when a corporation pays income tax on its earnings, and then its shareholders also pay income tax on the dividends they receive, which are paid out of the corporation's after-tax earnings.

2. The second way double taxation can occur is on an international level. This happens when a taxpayer resides in one country and earns income in another. Both countries may lay claim to tax the income, leading to double taxation.

This is particularly relevant for expatriates, who may be required to pay taxes in both their home country and the country where they are currently residing and earning income.

International double taxation

International double taxation is a major concern for expatriates and multinational corporations.

The US is one of the few countries that taxes its citizens on their worldwide income, regardless of where they live or earn their income.

This means that American expats are potentially subject to double taxation – once by the country where they earn their income, and again by the United States.

NOTE! There are mechanisms in place to prevent this kind of double taxation. Tax treaties between countries, the Foreign Earned Income Exclusion (FEIE), and the Foreign Tax Credit and more (we’ll cover them all in detail here below).

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Examples of double taxation

To better understand the concept of double taxation, let's consider a few examples:

Example 1: Corporate double taxation

A corporation in the United States earns $1 million in profits. It pays a corporate income tax on these profits.

Then, when the after-tax profits are distributed to shareholders as dividends, the shareholders must also pay personal income tax on these dividends.

Example 2. International double taxation

An American expatriate living in Germany earns income from a job in Germany. They pay income tax on this income to the German government.

However, as the United States taxes its citizens on worldwide income, the expat must also report this income to the IRS, potentially leading to double taxation.

Example 3: Investment income from a foreign source

Consider an American expatriate living in France who receives investment income, such as dividends or interest, from US-based stocks.

The US taxes this investment income because it’s sourced from the US, while France also taxes it since the individual is considered a tax resident in France. Without planning or claiming available credits, this income could be taxed twice, by both the US and France.

To avoid double taxation, the expat can claim the Foreign Tax Credit (FTC) on their US return for the taxes paid to France or apply the US-France tax treaty provisions, if applicable.

Business entities and double taxation

When it comes to business entities, double taxation primarily affects C corporations, often referred to as C-Corps.

This is due to the fact that C corporations are legally considered separate entities from their owners, who are the shareholders.

This separation leads to a two-tier taxation system.

First tier

The first tier of taxation occurs at the corporate level. When a C corporation generates profits, these earnings are taxed according to the prevailing corporate tax rate.

As of the current tax year, this rate stands at 21%, and it applies irrespective of the corporation's annual earnings.

Second tier

The second tier of taxation comes into play when these after-tax profits are distributed to shareholders in the form of dividends.

At this stage, the dividends are subjected to personal income tax, which varies based on the shareholder's federal income tax bracket.

This bracket is determined by several factors, including the shareholder's filing status (single, head of household, married filing jointly, or married filing separately) and the total amount of dividends received.

Exclusions

However, not all business entities are subject to double taxation.

S corporations, partnerships, and sole proprietorships, for instance, are classified as "pass-through" entities.

In these business structures, the income earned by the business is not taxed at the corporate level. Instead, it "passes through" to the owners, who then report it on their personal income tax returns.

This pass-through mechanism allows these types of businesses to avoid the double taxation experienced by C corporations.

Debate on fairness of double taxation

The fairness of double taxation is a subject of ongoing debate, particularly regarding passive income like dividends. Critics argue that it’s unfair to tax shareholders on dividends since these funds were already taxed at the corporate level.

For US expatriates, this can feel especially burdensome, as dividends earned abroad may be taxed in both the foreign country and the US, despite being the result of the same income stream.

On the other hand, proponents of double taxation argue that without taxes on dividends, high-net-worth individuals could potentially avoid taxes altogether by relying primarily on investment income instead of earned income.

For expats, these varying perspectives on double taxation highlight the importance of utilizing available credits and exclusions to reduce the impact of double taxation, whether on dividends or other income types.

Can I avoid double taxation?

Yes, there are several strategies that can be used to avoid or minimize double taxation.

These include:

1. Choosing a pass-through entity: As mentioned above, S corporations, partnerships, and sole proprietorships are not subject to double taxation. If you are starting a business, choosing one of these entity types can help you avoid double taxation.
2. Paying salaries instead of dividends: Since salaries are considered a business expense, they are not subject to double taxation. By paying out profits in the form of salaries rather than dividends, a corporation can avoid double taxation.
3. Tax treaties: Many countries have tax treaties in place to prevent double taxation. These treaties often provide rules for which country has the right to tax certain types of income.
4. Foreign tax credits and exclusions: For US taxpayers earning income abroad, the IRS offers foreign tax credits and exclusions that can help mitigate the impact of double taxation.
5. Foreign Earned Income Exclusion (FEIE): The FEIE allows US taxpayers to exclude a certain amount of their foreign earned income from their US taxable income each year. For 2024, the maximum exclusion amount is $126,500.
6. Housing exclusion or deduction: In addition to the FEIE, US taxpayers living abroad may also qualify for a housing exclusion or deduction.

NB! Remember, every individual's tax situation is unique, and the information provided here is general in nature.

It's always a good idea to consult with a tax pro who is familiar with the tax rules of both the US and the foreign country where you are living or doing business.