Final answer:
Paying a salary to an employee-shareholder is an effective way to mitigate double taxation of corporate income. The business can deduct the salary expense from its taxable income, reducing the amount subject to taxation. The employee-shareholder then pays individual income tax on the salary.
Step-by-step explanation:
Paying a salary to an employee-shareholder is an effective way to mitigate the double taxation of corporate income because it allows the business to deduct the salary expense from its taxable income. This reduces the amount of corporate income subject to taxation. The employee-shareholder then pays individual income tax on their salary, but this is typically at a lower tax rate than the corporate income tax.
For example, if a corporation earns $100,000 in profits and chooses to pay a $50,000 salary to an employee-shareholder, the corporation can deduct the $50,000 as a business expense. The remaining $50,000 is then taxed as corporate income. If the corporate income tax rate is 21%, the corporation would pay $10,500 in taxes on the $50,000. The employee-shareholder would pay individual income tax on the $50,000 salary at their applicable tax rate, which may be lower than 21%. This effectively reduces the overall tax burden.
Paying a salary to an employee-shareholder also has the benefit of increasing the payment received for work. This can be motivating for employees and lead to improved productivity. Additionally, the employee-shareholder may be eligible for certain tax deductions or benefits that are not available to shareholders receiving only dividend income.