If you’re a shareholder of an incorporated business, you might want to explore the option of issuing shareholder loans as a means of tax planning. A shareholder loan is an agreement to borrow money from your corporation for a particular purpose. Essentially, it’s a form of compensation that’s akin to receiving a salary or dividends, except that the funds are withdrawn from the corporation on a temporary basis.
What exactly is a shareholder loan?
A shareholder loan, also known as a “draw” or “due from shareholder” transaction, is an arrangement in which a shareholder borrows money from their company. It is required to repay it in the future.
Under the Income Tax Act, a shareholder who takes out a loan from their corporation is not obligated to report it as personal income on their tax return for that fiscal year. However, the loan must be repaid to the corporation by the end of the following fiscal year to avoid taxation. To qualify for this tax treatment, the corporation must charge interest on the loan at a prescribed rate, according to the Canada Revenue Agency. It’s crucial to document all loans with a written agreement or corporate resolution that specifies the repayment terms.
For instance, let’s say Mark owns a corporation with a year-end of December 31, 2020. He can withdraw a shareholder loan from the corporation at any point during 2020 without declaring it. As personal income, provided that he repays the loan plus prescribed rate interest (currently at one percent) by December 31, 2021. Therefore, if Mark borrowed $50,000 from his corporation in January 2020, he would not need to report it as personal income in 2020. However, he would be required to return the shareholder loan plus interest. Which means he’d have to repay $50,500 (principal + $50,000 x 1%) by December 2021. This arrangement allowed Mark to borrow funds from his corporation at a minimal interest rate for almost two years.
Changes to Interest Rates:
The Canada Revenue Agency (CRA), a federal government agency, determines the interest rates for shareholder loans on a quarterly basis. Listed below are the changes made to the shareholder loan interest rates between 2009 and 2020:
- From April 1, 2009, to March 31, 2018, the shareholder loan interest rate was 1%.
- As of July 1, 2020, the shareholder loan interest rate was reduced to 1% in response to the ongoing COVID-19 pandemic’s economic repercussions.
Advantages of Shareholder loan
A Shareholder loan offers several advantages over receiving a salary or dividend, primarily the ability to withdraw money from the corporation without incurring tax liabilities. However, while this benefit allows for planning opportunities, it can also encourage shareholders to exploit the rules. Consequently, the Income Tax Act includes the principal loan amount of any shareholder loan as part of the taxpayer’s income by default. To avoid costly or unintended tax consequences, it’s crucial to ensure that the loan satisfies one of the following conditions.
Conditions for Shareholder Loans
There are specific conditions that must be met for a shareholder loan to be considered legitimate. These include:
- The loan must have been granted to either you or your spouse for the purpose of buying a home to live in, and it should have been given to you in your capacity as an employee of the corporation, with bona fide arrangements in place.
- The loan must have been granted to you for acquiring a motor vehicle for use in the company’s operations, and it should have been given to you in your capacity as an employee of the corporation, with bona fide arrangements in place.
- The loan must have been repaid within one year of the end of the taxation year in which it was issued. For example, if the corporation has a calendar year-end and the loan was issued on February 28, 2019, it would need to be repaid by December 31, 2020.
To ensure that the loan is considered bona fide, you should be an active employee. Whom involved in the corporation’s operations, and it should be related to your employment. The repayment terms and interest rate should be reasonable and reflective. That two parties would typically agree upon in normal business practice. The Income Tax Act does not mandate that you document the bona fide arrangement. It is crucial to keep detailed records of the loan specifics at the time the loan is granted to avoid any ambiguity.
It’s important to note that the loan cannot be part of a series of loans and repayments. If the loan was repaid solely to avoid tax consequences, and a new one was issued the following year, this could constitute a series of loans and repayments. The resulting in the inclusion of the loan principal in the shareholder’s income in the year it was first granted. Additionally, the loan should include interest charged at the prescribed rate, which is currently set at 1% for 2020.
Additional Tips for Shareholder Loans and Taxes
When a shareholder loan does not meet the conditions outlined earlier, it is included in the shareholder’s income, and the corporation cannot deduct any expenses related to that. This can result in double taxation. However, any subsequent repayment of the loan can be deducted from the shareholder’s income in the year it is repaid. This rule can create tax planning opportunities in certain circumstances. For example, if a $10,000 shareholder loan is made to an adult child who is studying full-time. There would be no tax liability as the $10,000 income inclusion would be sheltered by the basic personal tax credit. When the child commences work and repays it, they can deduct $10,000 from their income in a higher tax bracket. The resulting in a tax savings of $3,000 if their marginal tax rate is 30% at that time.
Although the corporation is in the same cash position after the loan is repaid, your child would benefit from the $3,000 tax savings. At SRJCA, our team of Chartered Accountants can help your corporation pass on crucial tax savings through proper tax planning initiatives, as we have been doing for thousands of corporate and personal clients every year.
It is crucial to ensure that the Canada Revenue Agency (CRA) does not penalize you for improperly withdrawing a shareholder loan. As it can have serious consequences for your personal and corporate income tax planning. In the worst-case scenario, the CRA can add the full amount of the loan plus interest to the shareholder’s income for the year of it and not allow a deduction at the corporate level. To avoid this, planning for repayment within two corporate fiscal year ends is a reliable course of action. Having an experienced accounting team in place to plan, monitor, and execute transactions is crucial for any corporation.
Rewarding key employees with automobile and housing loans is a valuable tax tip for corporations. The Income Tax Act (ITA) allows corporations to enter into a bona fide loan agreement with employees to acquire a vehicle or a home. Which creates deeper, more loyal bonds and instills trust in both parties. Employees benefit from minimal interest rates. They would not be able to receive elsewhere, and a sense of gratitude is instilled in them towards their employer.
While there is a risk that an employee may default on the loan, the owner-operator of the corporation. That can mitigate this risk by having transparency on payroll, expenses, revenue, and forecasts. This allows for a reasonable loan amount to be determined. It is crucial to document and sign any agreement of a Shareholder Loan to an employee of your corporation, no matter your risk appetite.
A Chartered Accountant from SRJCA can help corporations plan and navigate the steps required to complete agreement and execute an employee Shareholder Loan. Seeking professional advice is important when planning for a Shareholder Loan to avoid unnecessary penalties from the CRA. If tax planning opportunities arise, they can be used to create value through tax savings. As Chartered Accountants in Toronto and Mississauga, we highly recommend seeking professional advice before contemplating the use of shareholder loans.
Is it possible for loans to shareholders to be viewed as personal income?
It is crucial to properly document all shareholder loans through written agreements or corporate resolutions. It outlines the repayment terms to the corporation. Failure to structure these loans properly could result in them being considered as income to the shareholder. Therefore, it is important to ensure that all shareholder loans meet the repayment guidelines. They are used appropriately in the shareholder’s capacity as an employee. Seeking advice from accounting professionals can help avoid any unnecessary penalties from the CRA. It may violate the Income Tax Act (ITA).