Double taxation is a nightmare. We don’t want you to have to pay tax at all, much less twice.
Unfortunately, in the United States, double taxation is a part of life, particularly when it comes to corporations.
Double taxation can occur when:
Two or more governments tax the same income, or
Corporations and shareholders both pay tax on the same income.
Governments at every level rely on taxes for funding, whether the government is national, state, or local.
Depending on where you live, you might have quite a few government entities reaching their hands in your direction.
The federal government gives you a deduction for the taxes you pay to state and local government.1 This deduction is not complete relief, however, and depending on where you live, you may not be able to completely escape double taxation.
Double tax among states. If you earn income in multiple states, you may have to deal with multiple state income taxes.
Fortunately, states use a combination of apportionment and tax credits to minimize or eliminate double taxation.
People commonly refer to our corporate tax system as a double taxation system.
Really, the better way to describe corporate tax is as a “two-tier tax system.” Corporate tax is not like the multiple government situation, where two or more governments tax the same taxpayer.
Instead, with corporate tax, the same government taxes two different taxpayers: the corporation and the shareholder.
Here is how it works. If you own a corporation, the government taxes both you and your corporation:
First, the corporation pays income tax at corporate rates.
Second, you as a shareholder pay tax on the dividend you receive from the corporation.
Pass-Through Taxation. You can avoid the two-tier tax system if you convert your corporation into an S corporation.
Corporations Owning Corporations. Many corporations own subsidiary corporations (and those subsidiaries might own subsidiaries).
You can imagine the problem that might happen if each of these corporations paid taxes on the dividends. There might be triple, quadruple, or quintuple taxation before the income ultimately reached the shareholders.
Fortunately, there are tax breaks for corporate owners. Corporations can deduct up to 100% of the dividends they receive from other corporations, depending on the percentage of stock they own in the distributing corporation.2
1 IRC Section 164. For purposes of the alternative minimum tax, however, you cannot deduct state and local taxes. IRC Section 56(b)(1)(ii).
2 IRC Section 243.