Double Taxation & the IRS
Double Taxation: The general IRS income tax rule is that when a person earns income, they are taxed on the income. There are various different types of taxation, but the focus of this article will be the double taxation of income earned from a corporation, and/or double-taxation of income earned from overseas, including: employment income, rental income, and investment income such as dividends and capital gains, bank interest, royalties, etc.
In general, double taxation tends to occur in two main situations:
- Business Income
- Foreign Income Taxes Paid
Business Double Taxation
When a taxpayer owns a business, the business is taxed on the income.
Likewise, when the business distributes income, the income that is distributed is also subject tax. As a result, this may lead to double taxation.
There are various different types of entities, and the structure of the entity will determine if double taxation is an issue.
Not all entities are subject to double-taxation rules. In addition, corporate relationships such as sister/brother or parent/child may alter the tax outcome.
With a C-Corporation, the income is taxed twice, hence double-taxation.
The first-level of taxation occurs at the corporate level when the income is earned.
The second-level of taxation occurs when the corporation issues a dividend to a taxpayer.
The Taxpayer then pays tax on the income received from the dividend.
Unlike a C-Corporations, and S-Corporation is referred to as a “pass-through.”
Technically, the S-Corp is actually an election that is made by the taxpayers.
First, the corporation or LLC is created, and then the election is made to be treated as an S-Corp.
S-Corps have very specific requirements and limitations, including:
- Less than 100 shareholders
- Location in the U.S.
- Reasonable Salary paid.
As a result, the income is not taxed at the corporate level. Rather, it passess through to the owners of the S-Corporation.
An LLC is a type of entity, in which the owners are taxed instead of entity.
Thus, there is no corporate-level tax for the LLC as well.
There are certain requirements involving self-employment tax — although the members are not required to file a corporate tax return.
International Double Taxation
As a law firm that specializes in International Tax, double taxation is a very common (and important) issue for taxpayers who have foreign income and paid tax on the foreign income.
In order to avoid double taxation, a person can claim a foreign tax credit.
Individuals claim foreign tax credits on a Form 1116.
While the foreign tax credit is not necessarily a “dollar-for-dollar” credit, it can reduce all the U.S. tax liability in some instances.
It can be used for both earned income (employment), self-employment and investment income (Capital Gains, Dividends, and Interest)
Example of Foreign Tax Credit Avoidance of Double Taxation
Marina resides in the U.S., but earns $40,000 a year in foreign investment income. The investment bank withholds $15,000 a year for taxes.
When Marina files her U.S. tax return, she will include a Form 1116 to claim the foreign tax credits.
Depending on Marina’s U.S. Tax Liability, her foreign tax credit may serve to reduce and/or eliminate U.S. tax liability on the same foreign income.
Foreign Tax Credits are subject to HTKO limitations (High-Tax Kick Out).
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