Knowing Your Worth: What Does Double Taxation Mean?

Taxes are one of the many obligations you must fulfill as a business owner. Most businesses are only taxed once, but others are subject to a more complex tax structure called double taxation.

Double taxation happens when a business entity is taxed twice on the same source of income. It’s a common phenomenon that significantly impacts a business’s bottom line. The more taxes you pay, the less profit you take home.

Fortunately, there are several ways to avoid double taxation, and today, we’ll explore each one in depth. Below, we’ll discuss what double taxation means and seven ways to avoid it.

Read on to learn how to reduce your business’s taxes effectively.

What Does Double Taxation Mean?

Double taxation is a tax structure in which a business is taxed twice on the same source of income. It typically occurs in two scenarios: corporate and international double taxation.

Corporate Double Taxation

Corporate double taxation happens when a corporation or an entity with a C-corp status is taxed at both corporate and individual levels.

Since corporations are considered separate legal entities, they must pay taxes on any income they generate. Any dividends they pay their shareholders will also be taxed based on their individual income tax rates.

International Double Taxation

On the other hand, international double taxation occurs when a multinational company is taxed in its home and host countries. The home country is where a business is originally incorporated, while the host country is where it operates and generates income.

For example, a Delaware corporation operating in Canada will be subject to US and Canadian taxes.

How to Avoid Double Taxation

Although double taxation is a common scenario for many entrepreneurs, it doesn’t mean it can’t be avoided. There are several strategies you can do to avoid getting taxed twice, such as:

Structure your business as a pass-through entity.

If you haven’t incorporated your business, structuring it as a pass-through entity can help you avoid double taxation.

Pass-through entities, like sole proprietorships, partnerships, and limited liability companies (LLCs), pass their profits and losses to their owners, meaning the business won’t have to pay any taxes. Instead, its owners will report their share of the business’s income on their tax returns and be taxed based on their tax rates.

LLCs are deemed the best choice of all three pass-through entities since they offer the same limited liability as corporations.

Find a tax-friendly state.

The state in which you incorporate your business can also significantly impact your tax burden. Some states have high-income tax rates, while others don’t. Examples of this include:

• Alaska
• Florida
• Nevada
• New Hampshire
• South Dakota
• Tennessee
• Texas
• Washington
• Wyoming

If you incorporate your business in one of these states, you can prevent paying taxes on your corporate income and get more tax savings.

Pay salaries instead of dividends.

Instead of distributing profit as dividends, you can pay your shareholders salaries. Although this doesn’t necessarily prevent double taxation, it can reduce your overall tax burden by deducting salary expenses and lowering its taxable income.

However, this strategy must be implemented with caution. The salaries your corporation pays must be reasonable to prevent receiving scrutiny from the IRS.

Change your corporation’s tax status.

Corporations can change their tax election from C-corporation to S-corporation, which offers a pass-through tax treatment similar to that of LLCs. However, the IRS only grants this tax status to businesses that fit the following criteria:

• The corporation must be incorporated domestically.
• The corporation must have only one class of stock.
• The corporation must have no more than 100 shareholders.
• The corporation’s shareholders must be individuals, specific trusts and estates, or certain tax-exempt organizations.

You must submit Form 2553 to the IRS to change your corporation’s tax election.

Check tax treaties.

The US has established several tax treaties with foreign countries, such as income tax treaties and totalization agreements, to prevent or reduce the impact of double taxation.

These treaties determine which country, whether the home or host country, has the right to tax certain incomes for citizens residing overseas. For instance, expats may still be required to report dividends to their country of residence, while their pension payments will be taxed in the US.

It’s worth noting that most US tax treaties have a saving clause guaranteeing each country the right to tax its citizens. You won’t be able to avoid double taxation, but you could reduce your liabilities.

Take advantage of the Foreign Earned Income Exclusion (FEIE).

The Foreign Earned Income Exclusion (FEIE) allows business owners to exclude a specific amount of foreign income from their taxes. According to the IRS, the FEIE can only exclude earned income or profit received as compensation for a specific service.

Examples of this include:

• Salaries
• Wages
• Commissions
• Bonuses
• Tips
• Self-employed income

You cannot use it for interests, dividends, capital gains, and other forms of unearned income.

The maximum exclusion for FEIE changes each year; this year, the limit will be $126,000, up from $120,000 last year.

Claim foreign tax credits.

Claiming foreign tax credits is one of the easiest ways to reduce the impact of double taxation on your bottom line. This program was designed to help Americans living abroad.

If you qualify for the Foreign Tax Credit, the IRS will grant you a tax credit equal to the amount you’ve paid for foreign income taxes. In other cases, they will credit you the full amount.

If your credit exceeds the amount of your foreign taxes, you can carry the excess forward and use it to reduce your liabilities in the following years.

Protect Your Bottom Line & Form An LLC Today

Although all seven strategies we’ve discussed are helpful, the best way to avoid double taxation is by structuring your business as an LLC.

LLCs will help you reduce your tax liabilities and protect your personal assets from the common pitfalls of running a small business, such as debt, lawsuits, and other liabilities.

Form an LLC today for free with Inc. Authority’s help! Check out our free LLC formation services here and get started today.