What is Double Taxation?

Double taxation occurs whenever income tax is paid twice on the same income. The situation arises in a C corporation, where the corporation pays income tax on its earnings and then issues dividends to its shareholders, who are taxed again on their dividend income. This situation arises because a C corporation is considered to be a separate legal entity from its shareholders.

How to Avoid Double Taxation

Because of its obvious negative effects, company owners try to avoid the situation by using the S corporation tax structure (which passes reported income directly through to shareholders), or by not issuing dividends. In smaller corporations where the employees are also the owners, double taxation can be avoided simply by raising compensation levels, so that reported income is always zero, and the shareholders receive the corporation's income through their paychecks.

Double Taxation in International Transactions

Double taxation is also possible in relation to international sales transactions, where two countries tax the same income. This can limit international trade when the resulting total tax leaves a minimal profit for the reporting entity.