Understanding shareholder loans and the tax pitfalls are crucial aspects in owning an incorporated business. Whether you own an incorporated business or are in the process of incorporating your business there are a few things you should know in order to avoid significant tax consequences.
There are significant tax rules associated with shareholder loan accounts that prevent shareholders from borrowing from their companies. Learning how to effectively manage your shareholder loan account will help you avoid costly tax consequences. If you are unsure what a shareholder loan account is, or how it is used, that’s okay, we’re here to help!
What is a shareholder loan?
Let’s start from the beginning, a shareholder loan is an amount that you, as a shareholder, owe to your corporation. A shareholder loan can be made to your own company, a company related to your company, or a partnership of which your company is a member.
In most cases, a shareholder is paid from the corporation through either salary or dividends.
In short, your shareholder loan account represents the amount of funds that you have contributed to the company net of the funds that you have withdrawn from the company. The position of this account at the company’s fiscal year-end date determines if any action is required for the shareholder to repay any amounts that he or she owes to the company. From a bookkeeping perspective, amounts contributed to the account are recorded as credits in the company’s general ledger and amounts withdrawn are recorded as debit entries.
If, for example, you have deposited more funds than you have withdrawn during the year, then the balance will be in a credit position, indicating that the company owes you money. The good news, this amount can be extracted by the shareholder at any time with no tax consequences.
If, however, you have withdrawn more funds than what was deposited during the year, the balance will be in a debit position, indicating that you owe the company money. If this loan is not repaid by the shareholder within 1 year after the end of the company’s taxation year, then tax problems arise.
Shareholder loan debit balance and repayment
If a shareholder loan debit balance is not repaid within 1 year of the fiscal year-end date, the Canada Revenue Agency (CRA) considers this loan to be personal income and will include the amount in the income of the shareholder in the year in which the loan was made. However, the company is not entitled to a deduction for this same amount, therefore, double taxation arises. If the shareholder repays the loan in a subsequent year, the shareholder can take a personal deduction for the amount repaid.
If the account balance is in a debit position at the end of the fiscal year, there are several options available to clear the balance:
- Repay the loan before the end of the next fiscal year using personal funds to deposit into the company. Note that the repayment cannot be a part of a series of loans and repayments, otherwise the loan principal will be included in the shareholder’s income in the year the loan was originally made.
- Record the payment of salary by the fiscal year-end date, in which case the payroll withholdings (i.e., CPP and taxes) must be remitted to CRA in the month following the fiscal year-end. The gross salary amount and the employer portion of the CPP expense are deductible to the company. Salaries generate RRSP contribution room and CPP pensionable earnings for the shareholder.
- Declare dividends to the shareholder at the fiscal year-end date. There are no source deductions on dividends, however, dividends are not deductible to the company. As well, dividends do not generate RRSP contribution room or CPP pensionable earnings for the shareholder. A directors resolution approving the dividend declaration needs to be prepared to document this transaction.
- Transfer personal assets (e.g., investments or rental property) to the corporation by the shareholder to reduce their indebtedness. This transfer can be done on a tax-deferred basis, however, this is a complex transaction that is beyond the scope of this article.
If salaries or dividends are used to clear the shareholder loan balance at fiscal year-end, then these must be reported on an annual information return – i.e., a T4 or T5 Summary, that must be filed no later than the end of February of the following calendar year. This return reports the income to the shareholder, which is then reported on their personal tax return and taxed at their marginal tax rate.
Compensation planning
When determining your compensation plan, there are a few things to consider. As the shareholder, your choice of salaries or dividends will depend on your personal tax and financial situation. Generally, there is little difference in the total tax paid when compensating through salaries or dividends, however, the timing of the payments may be different.
Best practices
One important aspect to note, your shareholder loan account should only be used for temporary financing needs as the repayment term is within 1 year from the date of borrowing. Here are a few best practices we recommend in order to ensure success.
- Always accurately record transactions in your shareholder account in order to properly monitor the ending balance, this will help when it comes time to address repayment options if necessary.
- As a shareholder, you should review the account details carefully to ensure that transactions have been properly recorded.
- We always recommend clearing the shareholder loan balance each year to provide increased flexibility should a larger loan be required from the company.
Lott & Company can help provide advice on monitoring your shareholder loan balance and options for compensation if repayment is necessary. If you have any questions, please contact our office to be connected to one of our team members.
