As we have discussed in a previous blog, the time may come when a business owner or shareholder will want to withdraw funds from their corporation. While claiming a salary or paying dividends are potential solutions, each with its own set of positive and negative implications, some shareholders may also consider a shareholder loan as a possibility. Few things, however, make an accountant groan like a loan issued from a corporation to its shareholder.
Unfortunately, it’s a story as old as time—or at least as old as the Income Tax Act. A shareholder needs cash—temporarily, they tell themselves—and going to the bank is a pain. Borrowing from the company is easier. They don’t want to pay personal tax on the funds, so instead of taking salary income or a dividend, they borrow the money, thinking they’ve discovered an easier way to get through a temporary cash crunch. In reality, they’ve just made their lives much more difficult.
On the surface, a corporation loaning funds to a shareholder can appear like a fast and easy solution to generate cash with few repercussions. However, shareholder loans come with a host of complications and hidden pitfalls business owners should keep in mind.
The Pitfall of Imputed Interest Benefit
There is an economic benefit to you, personally, if you borrow money and don’t pay interest. The Income Tax Act contains rules that effectively add that economic benefit to your income so that you pay tax on it. The benefit, officially called the Imputed Interest Benefit, is calculated as follows:
Amount of the loan x prescribed rate – any interest paid
The prescribed rate is set quarterly. As of July 1, 2022, this rate is 2%. If you pay interest to your company on the loan, you can subtract the amount paid from the benefit calculation.
So, if you borrowed $100,000 interest-free from your company on July 1, 2022, and repaid it on July 31, 2022, then the benefit to be added to your income would be 100,000 x 0.02 x 31/365 = $169.86. This isn’t such a big deal to calculate if it’s for one advance. But imagine how much fun it would be if you took $10,600 on July 1, another $20,150 on July 15, repaid $4,522 on August 1, then withdrew $15,018 on September 5… You get the idea. Things can get complicated quickly!
It’s important to note that this scenario only applies when you, the shareholder, owe the company money. If the company owes you money, there won’t be any imputed interest benefit to calculate, even if you make a ton of deposits and withdrawals. Provided the loan stays in a credit balance with the company owing you money throughout the year, there will be no imputed interest benefit to calculate.
The Pitfall of a Loan Treated as Income
A loan treated as income is, perhaps, the worst pitfall of all because it’s big money. If the loan is outstanding for two corporate year ends, it gets treated as personal income retroactively. As an example, let’s say that you borrowed $200,000 from your company on July 1, 2021, and the company’s fiscal year-end is July 31. On the July 31, 2021 corporate balance sheet, the company would show a loan receivable from you of $200,000. If that loan is still outstanding as of July 31, 2022, the full amount gets added to your personal income for the 2021 tax year. Depending on your tax bracket, this could result in $106,000 of personal tax to pay.
The (minor) good news is that a deduction is available when the loan is eventually repaid.
Are there any exceptions?
When it comes to withdrawing funds from your corporation, there are a variety of options business owners and shareholders can explore. However, ensuring you are making those decisions fully informed about the benefits as well as potential consequences is essential to make certain you and your business achieve the best possible outcome while remaining compliant—especially when considering a shareholder loan.
If you are thinking about borrowing money from your company, it’s essential you contact your McCay Duff LLP advisor before you advance the funds, so that we can help you navigate and avoid the tax pitfalls of shareholder loans.
Contact McCay Duff LLP in Ottawa for Comprehensive Tax Solutions
At McCay Duff LLP, our trusted team of Chartered Professional Accountants provides high-quality tax and business advisory services to Ottawa and surrounding area businesses. Our expert tax advice, planning and preparation help corporations maximize profitability and minimize tax obligations while remaining compliant. To learn more about how our experienced advisors can help you and your business, contact us online or by telephone at 613-236-2367 or toll-free at 1-800-267-6551.