Future Business Leaders of America (FBLA) Entrepreneurship Practice Test

What will happen when a corporation lowers or eliminates its profit by paying out as much as they reasonably can to its owners?

1. The owners will pay individual income tax, but the corporation will avoid paying on its income.

2. The owners will avoid personal tax on dividends.

3. The corporation will benefit from a tax deduction.

4. The owners will incur capital gains taxes.

The correct answer is: The owners will pay individual income tax, but the corporation will avoid paying on its income.

When a corporation lowers or eliminates its profit by distributing most of its earnings to its owners, it often results in the owners receiving dividends. In this scenario, the corporation effectively reduces its taxable income, which can lead to a situation where it avoids paying additional corporate income tax on the profits that have been distributed. This principle stems from the taxation structure for corporations and their owners. When dividends are paid out, those distributions are counted as income for the owners, who then pay personal income taxes on that income. However, since the corporation is distributing its earnings rather than retaining them, it reduces its taxable income and may not face corporate tax on the portion that is distributed. This creates a tax scenario where the corporation may minimize its tax obligations while the owners pay tax on their individual income derived from those dividends. Other options are less relevant in this context. For instance, avoiding personal tax on dividends is incorrect because owners still have to report those dividends as income. Similarly, while capital gains may apply under different circumstances, they are associated with selling an asset at a profit, not with receiving dividends. Thus, the emphasis on the corporate tax and the individual tax implications accurately reflect the financial dynamics involved when a corporation alters its profit distribution strategy.