Avoiding Double Income Taxation

Northwest Brands

Avoiding Double-Income Taxation

Northwest Brands, Inc., is a small business incorporated in Minnesota. Its one class of stock is owned by twelve members of a single family. Ordinarily, corporate income is taxed at the corporate and shareholder levels. Is there a way for Northwest Brands to avoid this double-income taxation? Explain your answer.

Because corporations are considered fictional 'persons' under the law, they are taxed as separate entities. The incomes of their owners (shareholders) and employees (from the most lower-level employees to the members of the boards of directors) are all subjected to income tax. This is called double taxation as income is taxed "once to the corporation itself and then a second time when earnings are paid out to the corporation's owners (shareholders). This is true only for earnings paid out to shareholders in the form of dividends -- that is, profits paid by the corporation to its shareholders in return for their investment in the company" (What is double taxation, 2013, Nolo). While the policy of double taxation makes sense when taxing the profits of a large corporate entity which is owned by thousands of shareholders and has an independently-operating CEO, for smaller companies, incorporation could theoretically mean that the organization would be subjected to a considerable disadvantage in terms of tax policy: the income of the owners could be taxed from running the business as well as the income owners derived from holding shares.

However, in the case of Northwestern Brands, Inc. this worst-case scenario is unlikely to transpire. "In practice, this sort of double taxation seldom occurs in a small corporation" (What is double taxation, 2013, Nolo). With a very small company in which the owners make up the entirety of the shareholders, there is no pressure to pay dividends to shareholders, hence the company seldom does so. Instead, the limited number of shareholders (in this case, only twelve), will "work for the corporation and pay themselves salaries and bonuses. Because the corporation can deduct salaries and bonuses as ordinary and necessary business expenses, it doesn't have to pay corporate tax on them" and will only have to pay individual taxes (What is double taxation, 2013, Nolo). Individual shareholder interests are thus in harmony with the future, long-term health and growth of the company, not competing with it as in the case of larger entities.