Northwest Brands, Inc., is a small business incorporated in Minnesota. It's one class of stock is owned by twelve members of a single family. Ordinarily, corporate income is taxed at the corporate...

Northwest Brands, Inc., is a small business incorporated in Minnesota. It's 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 and what is the explanation of the answer?

Asked on by berty63

2 Answers | Add Yours

kplhardison's profile pic

Karen P.L. Hardison | College Teacher | eNotes Employee

Posted on

The concept of double taxation on a family owned corporation may be difficult to understand. As a corporation, Northwest Brands will be taxed on annual profit. As a family owned corporation, each of the twelve family members will be taxed on income generated by their shares of interest in corporate profits.

Since, in the case of family-owned Northwest, the shareholders (who are taxed on income generated by share dividends) are the same people as the officers representing the corporation (which is taxed on corporate profit), the twelve family members, who are corporation owners and shareholders (the twelve individuals fill two roles at once), are faced with paying taxes twice, once as corporate profit taxation and then again a second time as shareholder personal income taxation. In other words, since the twelve people fill two roles at one and the same time, they, as such, have two separate taxation burdens.

Definitions

Double taxation, therefore, is when taxes are levied on the corporation's profits and levied again on shareholders personal income when the corporation owners and the individual shareholders are the same individuals. This can be made more clear by examining the definitions of three relevant terms: corporate taxation, corporate dividends, personal income:  

  • corporation taxes: taxes paid on all corporate profits (less business expense deductions); profits consist of money paid to shareholders as dividends and money retained in the corporation for operational expenses or for growth expansion.  
  • corporate dividends: distribution of after-tax payments of corporate profits among shareholders.
  • personal income: compensation from wages, salaries, bonuses, freelance earnings, self-employment earnings, corporate dividend distributions, gains from investments, property sales and property rental receipts, etc.

These definitions show that corporate taxes and personal income overlap through the agency of corporate dividends. After corporations pay their corporate taxes, they distribute profit earnings to shareholders as dividends. Shareholders receive dividends as personal income upon which they pay personal income taxes. When the corporation owners and the shareholders are the same persons, they pay taxes twice: they undergo double taxation since they represent two distinct entities, a corporate entity and a personal entity, each of which is taxed on profits/earnings.

It should be more clear now what double taxation in a regular corporation (a C-Corporation) is, why it is important to avoid it and why it poses a difficulty for the twelve family members of Northwest Brands Corporation.

Solutions

The solution to double taxation in a regular C-Corporation is to establish a business as--or move an existing business to--one of the "pass-through" entities: partnership, sole proprietorship, limited liability corporation (LLCs) and S-Corporation.

If a corporate form of business is required or preferred, there are two corporate pass-through options: the limited liability corporation and the S-Corporation.

Pass-Through Taxation

A "pass-through" business is one in which the profits/earnings/income passes through the business structure--is not taxed by the business--and passes to the owners/partners/shareholders. Both an LLC and an S-Corp allow profit, income and earnings to pass through the business structure and pass directly to individuals as personal income. Because of taxation pass-through, the business pays no taxes on profits/earnings. The tax burden passes through to the individual who pays individual income taxes on income passed through to them from the business structure. (A sole proprietorship and some LLCs will have single individuals receiving pass-through income while partnerships and S-Corps may have two or more individuals receiving pass-through taxation income.)

Northwest Brands Inc.

Northwest Brands Corporation, therefore, has two options available. They can move to either an LLC or to an S-Corp. An S-Corp may comprise no more than 100 shareholders. Thus Northwest, with its twelve shareholders, may move from their present C-Corp, double taxation structure to an S-Corp structure. There are no minimums set for LLCs, thus Northwest may also move from their C-Corp structure to an LLC structure, although the legal filing fee for LLC is generally more than for an S-Corp. Either structure will establish pass-through taxation thus eliminating the problem of double-taxation.

Because LLCs have fewer rules and restrictions governing them, thus are simpler to set up and operate, they have become very popular, while S-Corps, with more restrictions and rules, have become less popular.

Sources:
karythcara's profile pic

Karyth Cara | College Teacher | (Level 1) Senior Educator

Posted on

When shareholders are corporation owners, double taxation accrues when the corporation distributes dividends to shareholders. This is because corporations are taxable as legal entities and, at present, shareholder dividends (upon which corporations have already paid tax on as earnings) are taxed as personal income on shareholders' personal income tax reports.

In order for a corporation like family owned Northwest Brands, Inc., to avoid double taxation they can simply not issue dividends from the profits. An option for a corporation with 100 qualified shareholders or more is to set up an S corporation structure in which the corporation passes corporate income, losses, deductions, and credits through to their shareholders. This won't work for Northwest though since they have only 12 shareholders.

Salaries are deducted from corporation's taxable income since salaries are payable liabilities. Some corporations like Northwest take advantage of this by setting up family shareholders as employees and paying profit sharing as salaries or consulting fees. Any surplus income earnings, after paying salaries and consulting fees, would be retained to finance company growth since income diverted to funding growth is taxed at a lower rate than profit.

Sources:

We’ve answered 318,975 questions. We can answer yours, too.

Ask a question