Shareholder Loans: Beware Of Taxable Events
In general terms, a shareholder is subject to tax on the value of any assets withdrawn, whether directly or indirectly, from his or her company. This would include physical assets or money, such as dividends, a draw or a loan. Some of the exceptions to this general rule include a withdrawal of paid-up capital, payment of an amount owing to the shareholder by the corporation, and capital dividends. There are unique tax consequences depending upon the nature of the withdrawal.
Salaries and bonuses are taxable as income to the shareholder in the year received, and would be subject to source deductions (also known as tax withholding) by the corporation. The requirement for the corporation to withhold income tax and other payroll deductions creates a prepayment of some or all of the resulting tax. Later, when the shareholder files his or her tax return, the amount of income tax withheld can be applied as a credit to offset the individual’s income tax liability.
Dividends paid to the shareholder are taxable in the year received and are subject to the gross-up and dividend tax credit rules. While dividends are not subject to source deduction withholding, they can trigger an obligation for the shareholder to make income tax instalments. Overlooking required income tax instalments can result in interest charges to the shareholder.
When a shareholder draws money from the corporation, and it is not labelled as salary or dividends, the withdrawal is often treated as a loan to the shareholder. The general rule is that any outstanding balance of the loan is taxable to the shareholder one year after the end of the corporate year- end in which the loan was made.
For example, a shareholder makes several draws totalling $200,000 over the course of the corporation’s fiscal year ending June 30, 2013. This means the shareholder owes the company $200,000 at year-end. The shareholder would be taxable on the $200,000 loan if it is still outstanding on the company’s June 30, 2014, year-end.
From a planning perspective this shareholder could repay the entire loan and avoid the income inclusion. Either he could repay some of the loan, and reduce the income inclusion, or the corporation could declare a bonus or a dividend equal to the outstanding balance of the loan, use the amount to offset the loan, and include the applicable dividend or bonus amount in his 2014 income. This allows the shareholder some control over the tax consequences; a dividend receives special tax treatment, and a bonus would be tax-deductible to the corporation.
Where a withdrawal from a corporation is not appropriately categorized and tax-reported (for example, in the corporate accounting books, board resolutions and any applicable tax slips), the Canada Revenue Agency (CRA) is likely to treat the amount as a shareholder benefit. In other words, the amount will be fully included in the shareholder’s income, and no deduction will generally be allowed to the corporation. This creates double taxation that could have been avoided through appropriate documentation and reporting.
In situations where the shareholder is also an employee, there are exceptions with respect to how loans are treated if the loan is made to the individual in his capacity as an employee rather than as a shareholder. To satisfy the CRA that the loan was made because of employment, all employees within the particular class of employees to which the shareholder belongs must be eligible for similar loan benefits. Employee loans that are advanced under the following circumstances will not be treated as income to the recipient:
- Shareholders who own less than 10 per cent of the issued shares of the company;
- Loans received from the company to buy shares of the company;
- Loans received from the company to buy a home; and
- Loans received from the company to buy a car used in the performance of employment duties.
However, at the time the funds are advanced, there must be a bona fide plan in place outlining the terms for repayment within a reasonable timeframe, and an imputed interest benefit will be included in the employee’s income.
Shareholders cannot treat the company property as their own, but rather must recognize the income tax consequences that arise with most types of asset withdrawals. It is important to know before the issue arises when strategies can be deployed to avoid unnecessary tax consequences.
E.O. & E.
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Copywrite ISSN 0382-7038
Contributors to this edition:
James W. Kraft, cpa, ca, mtax, tep, cfp, clu, ch.f.c.
Deborah Kraft, mtax, tep, cfp, clu, ch.f.c.