Tax Tip Thursday

I want to talk about shareholder loans for people that have corporations.

Many owners of corporations do not understand how shareholder loans work and the implications of taking money out of their corporation.

We have had 2 clients this year that have created significant tax implications for themselves without being aware of what they were doing to themselves – one with tax implications of over $200k and the other closer to $500k.

Unfortunately, their accountants were both aware of the situation building up over years, but did not provide do anything about it.  I would NEVER let this happen to my clients.

The situation I am talking about is when you draw money out of your corporation, not through payroll with the appropriate tax and cpp deductions.

When you own a corporation, you can essentially take money out of the corporation in 3 ways.

Salary or wages or Bonus

Usually with a payroll provider (like The Mad Accountant), who processes your payroll, remits the appropriate taxes and cpp to the CRA, on a monthly basis, arranges direct deposit of your net pay to your bank account,  and prepares and submits the T4 and T4 summary at the end of the year.

Dividends

This can unfold in a couple of different ways.

1. You can actually set it up with a payroll provider and determine how often you would like to receive a payout as well as holding back and remitting taxes only to the CRA on your behalf and prepare and submit a T5 at the end of the year.
2. You can take money out of the corporation whenever you choose and however much you choose and you take responsibility for the tax you owe when your tax return is prepared and submitted.

Shareholder Loans

A shareholder loan is as it sounds, it is only a loan and either needs to be paid back or taken into income either by Dividends or Bonus.

I guess people think that they can just “borrow” the money from the corporation and then it is not income.

This is where people into trouble.

There are very specific rules about a shareholder loan and what qualifies and how it must be accounted for in the corporation and on your personal taxes.

Here is an overview:

In general, a legitimate shareholder loan is not considered taxable income, immediately, for the shareholder, if it is properly documented and repaid within a specific time frame, typically by the end of the corporation’s following fiscal year. Failure to meet these conditions results in the loan amount being included in the shareholder’s personal income and taxed accordingly. 

 

Key Rules for Avoiding Income Recognition

To ensure a shareholder loan is treated as a non-taxable loan and not as a taxable benefit (like a dividend or salary), specific conditions must be met:

• Bona Fide Loan: The transaction must genuinely be a loan, with a clear intention of repayment when the funds are advanced.
• Documentation: A formal, written loan agreement should be in place at the time the loan is made. This agreement should outline the loan amount, interest rate, and repayment terms.
• Repayment Deadline (“One-Year Rule”): The loan must be repaid within one year after the end of the corporation’s fiscal year in which the loan was made. For example, if a loan is made in Jan 2025 and the corporation’s fiscal year ends on December 31, 2025, the loan must be repaid by December 31, 2026 – so you theoretically, you can have use of the money for 2 full years less a day!
• Prescribed Interest Rates: The loan must charge interest at least equal to the government’s prescribed (or applicable federal) rate. If a lower rate or an interest-free loan is provided, the difference in interest is considered a taxable benefit to the shareholder and must be included in their income.
• Consistent Repayment: The repayment cannot be part of a “series of loans and repayments” that suggests an intent to circumvent the rules. A pattern of borrowing at the end of the year and repaying at the beginning of the next can be a red flag for tax authorities.
• Proper Record Keeping: All loan transactions and repayments must be accurately recorded in the corporation’s books and records. Inaccurate or incomplete bookkeeping can lead to the entire amount being reclassified as taxable income during an audit.

 

Consequences of Non-Compliance

If the rules are not followed, the consequences include:

• Income Inclusion: The full principal amount of the loan (plus any taxable interest benefit) is included in the shareholder’s personal income in the year the loan was made, and they must pay personal income tax on it at their marginal tax rate.
• Double Taxation: The company cannot deduct the loan amount as an expense, and the shareholder pays personal tax on it, potentially resulting in the same money being taxed twice.
• Penalties and Interest: Failure to comply with tax regulations can result in penalties and interest charges from the relevant tax authority.
• Forgiven Loans: If a shareholder loan is forgiven by the corporation, the forgiven amount is considered a dividend and is immediately taxed in the shareholder’s hands.

Exceptions

Certain exceptions may apply, such as:

• Loans made in the ordinary course of the corporation’s business of lending money.
• Loans made to a shareholder-employee for specific purposes, such as purchasing a primary residence, a vehicle for business use, or company shares, provided specific conditions and bona fide repayment arrangements are met.

How to avoid the problem

If you think you are in this situation, come see us right away.  These are the actions you should take:

• Having your bookkeeping kept up to date will help identify these problems.
• Meeting with your accountant and reviewing your tax return annually will also identify these problems as they occur.
• Being knowledgeable about your financial statements and/or tax returns will also benefit you.
• If your accountant is not making you aware of your shareholder balance, follow up and find out where you stand or you can of course come see The Mad Accountant

We are helping both of my clients the best we can, but there is no quick fix and it is a very risky situation that could place you in significant financial jeopardy. Please pay attention!

Learn the best way for your corporation to pay you! Make An Appointment today!

Disclaimer:

This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal or tax advice nor can it or should it be relied upon. All tax situations are specific to each individual. If you have specific tax questions you should book an appointment for a 1 on 1 consultation.