The Tax Benefits of Shareholder Loans
As a shareholder of an incorporated business you should consider the possibility of issuing shareholder loans as a tool for tax planning purposes. A shareholder loan is an agreement to borrow funds from your corporation for a specific purpose. In essence it is a form of remuneration similar to salary and dividends, where funds are withdrawn from the corporation, albeit temporarily.
One of the benefits of a shareholder loan, as opposed to a salary or dividend, is the ability to withdraw funds from the corporation without triggering a tax liability. This benefit creates planning opportunities but unfortunately it also creates more opportunities and incentives for shareholders to abuse the rules. As such, the Income Tax Act will by default include the principle loan amount of any shareholder loan into the taxpayer’s income unless the loan meets one of the conditions listed below:
– The 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 loan was made to you to acquire a motor vehicle to be used for the business’s operations, and you received the loan in your capacity as an employee of the corporation, and bona fide arrangements are met.*
– The loan was repaid within one year after the taxation year end in which the loan was made. For instance, assuming the corporation has a calendar year end a loan issued February 28, 2012 would have to be repaid by December 31, 2013.**
* An employee of the corporation is actively involved in the operations and not merely a passive shareholder and the loan should in substance be in relation to your employment. A bona fide arrangement requires that the loan repayment terms and the interest rate charged are reasonable and would reflect terms similar to a contract entered into between two parties in normal business practice. Although the Act does not require that you document the bona fide arrangement, it is crucial to properly document the specifics of the loan at the time the loan is made in order to avoid any ambiguity.
**The loan cannot be part of a series of loans and repayments. For instance, if in the above example the loan was repaid merely to avoid the tax consequences and a new loan was issued on January 1, 2014, this could constitute a series of loans and repayments and the loan principal could be included in the shareholder’s income in the year the loan was originally made. In addition, the loan should include interest charged at the prescribed rate (currently 1% in 2012).
Other Tax Planning Opportunities & Tax Tips
Any loan that does not meet one of the conditions above is included in the shareholder’s income. However, any subsequent repayment of the loan may be deducted from income in the year it is repaid. In certain circumstances this rule creates tax planning opportunities. For instance, if a $10,000 shareholder loan was made to your adult child studying full-time there would be no tax liability as the $10,000 income inclusion would be sheltered by the basic personal tax credit. Upon commencing work and repaying the loan, your child would deduct $10,000 from income in a higher tax bracket. If their marginal tax rate at that time is 30% that would create a tax savings of $3,000.
Ultimately, the corporation is in the same cash position after the loan is repaid but your child is $3,000 richer!
A shareholder loan can be very beneficial if you are considering buying a home, a car or are in need of short-term funding. If tax planning opportunities arise, they can also be used to create value through tax savings. As Chartered Accountants in Toronto and Mississauga we recommended you seek professional advice before contemplating the use of shareholder loans. Contact a Chartered Accountant for more tax tips by email at firstname.lastname@example.org or call us at 647-725-2537 for consultation.