In this article, you will learn what a shareholder loan is, and how to benefit from using it. After reading this article, you will be familiarised with it's advantages, restrictions, and how to take advantage of the tax benefits.
Understanding Shareholder Loans
As a shareholder of an incorporated business a wise tax planning strategy is to take into account the opportunity when issuing shareholder loans. In short, shareholder loans are an agreement to acquire capital from your corporation for a purpose. Although temporarily available, it can be used as compensation, similar to a salary, or dividends.
What is a Shareholder Loan?
Occasionally referred to as “Due to Shareholder” or “Due from Shareholder”, shareholder loans are debts owed to corporations from shareholders. Usually, any funds that a shareholder receives from the corporation is contributed to a shareholder's income and in turn, will be also taxed. However, Shareholder loans are different. Since shareholder loans are debts that must be paid back within a set period, they aren't usually recognized as income. This tactic has become desirable for owners/managers of businesses to use it as a benefit to create "tax free" personal payments, however, if you don't use precautions, you can still be taxed on the loan.
3 Common Shareholder Loans Uses
Now that you have an understanding of what Shareholder Loans are, it's time to learn the various ways they can be used.
1. Owner Cash Contributions & Withdrawals.
A business owner that is withdrawing money from a corporation is the common example as to how shareholder loans are used. An Accountant or bookkeeper is able to mark the transaction as a "due from shareholder" if the amount withdrawn is not indicated as a salary or dividend, creating a loan from the corporation, to the specified shareholder.
Vise versa, if an owner contributes by depositing capital as a shareholder to cover expenses, the accountant or bookkeeper may mark this as a "due to shareholder" transaction, as the amount loaned to the company is now due back to the shareholder.
2. Paying for Personal Expenses With Company Funds.
Most often owners are seen paying for personal expenses using their company funds. For example, a family trip to Hawaii paid by the company credit card, which is not tax deductible. When this occurs, the transaction is treated as a cash withdrawal. Therefore, the company won't be able to deduct the expense, becoming a debt that's owed back to the company.
The company can give the owner the benefit of the doubt, and say it was a mistake. The purchase can be recorded in the books under the owner's shareholder loan account as a loan from the company to the owner. But do not forget, the loan must still be repaid back to the company!
3. Paying for Company Expenses With Personal Funds.
Owner-managed companies are sometimes seen to pay for company expenses with a personal credit card whether by accident, or on purpose. Similar to the example above, this transaction can be later recorded as a cash contribution to the company. The company can get tax deduction later on, and the shareholder can be reimbursed after a certain period.
For example, the owner needs to purchase office supplies for his company, however, seemed to have misplaced his company credit card. If the owner uses his personal credit card for the purchase, the company can record the transaction as a the owners shareholder loan towards the company.
Interest Rates Associated to Shareholder Loans
It is important to understand that there are interest rates associated with shareholder loans. These interest rates are usually determined by the Canada Revenue Agency (CRA), which is facilitated by the Canadian Federal Government. As of July 1st, 2020, the shareholder loan interest rate issued by CRA was cut to 1% due to the circumstances regarding Covid-19. However, the interest rates may change per quarter, therefore it is best to always check the CRA Website to receive the most up-to-date information regarding changes in shareholder interest rates.
Shareholder Loan Tax Implications
In summary, shareholder loans are advantages a shareholders could receive for investing in their corporation. However, it is crucial for shareholders and corporations to understand the provisions in the Income Tax Act set by the CRA relating to shareholder loans, its rules, and their taxation. It is also important to implement effective business practises to prevent the abuse of shareholder loans by shareholders. Corporations should ensure that bona fide arrangements are made with shareholders for the repayment of the loan. These arrangements can be made via a written agreement or a corporate resolution setting out the terms and conditions of the loan.
Avoid Shareholder Loan Tax Problems
Repayment of the Loan on Time
The best way of avoiding tax problems is to repay the loan quickly, as noted in the section under "Tax Advantage of Shareholder Loans". If the shareholder repays the loan before the year end, they won’t have to pay tax personally on those funds. You must be careful to not repeat the same loan, since the CRA takes situations like this into account, and you could be taxed twice.
The repayment of the loan before the end of the year will avoid the tax problem, however, this means the shareholder cannot use the company card again for their trip to Hawaii!
Withdrawing Funds as Salary
Since the owner of a corporation can also be an employee, and wants to earn x amount from their company on an annual basis, the best way to avoid double taxation, is to declare the withdrawals as a wage, or salary.
The salary however would act as a tax deduction for the company and the owner needs to include it in his/her employment income, meaning they would receive less than the x amount they desired into their band, but can avoid the possibility of double taxation.
Withdrawing Funds as Dividends
Another way to avoid double taxation is for the funds to be paid out as a dividend. A Dividend would be declared and the owner can deposit the funds into their personal account. Dividends are taxed at a lower rate than employment income, although still taxed, it's another way to avoid double taxation.
Although the dividends paid to the shareholder are not faced with tax deduction during the time of transfer, the tax is still owed, and the shareholder would still need to pay when filing their tax return in April.
Tax Advantage of Shareholder Loans
An advantage seen regarding using shareholder loans, as opposed to a salary or dividend, is the ability to withdraw funds from the corporation without prompting tax liability. Unfortunately, since this form of common strategy has been abused by most businesses, the Income Tax Act includes the principal loan amount of any shareholder loan into the taxpayer’s income. Also, it is crucial that your loan meets requirements set by CRA to avoid hefty tax consequences. These requirements are, however, not limited to:
- The shareholder loan was made to you or your spouse to buy a home to inhabit, and you received the loan in your capacity as an employee of the corporation, and bona fide arrangements are met.
- The shareholder loan was made to acquire a motor vehicle specific for the business’s operations, and you received the loan as an employee of the corporation, and legitimate arrangements were met.
- The shareholder loan must be repaid within the taxation year end in which the loan was made. For example, a loan issued January 28, 2020, must be repaid by December 31, 2020, not January 28, 2021.
Check the CRA Website regarding requirements set by the CRA.
In conclusion, Shareholder loans can be a useful way for short-term personal cash needs. As well as, allowing shareholders more flexibility when wanting to withdraw cash from a company.
If you require a short-term loan for less than a year, a shareholder loan could be a quick and easy way to obtain the funds. However, the loan must be repaid within the year to avoid breaking the rules set forth by the CRA.
If you'd like to learn more in-depth regarding shareholder loans, salaries, or dividend payments, feel free to send us a message, or set up an appointment to meet with one of our accounting specialists in our Downtown location at Ebrahimi Accounting.
Note to reader:
Please note that the information presented in this article is to help provide you a general information. This article does not take into account your personal circumstances and should not be utilized without first speaking with an accounting professional. Ebrahimi Accounting will not be liable for any issues that may arise from using the information presented within this article. Please contact Ebrahimi Accounting for more Info.