Tax Benefits of Shareholder Loans

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  In essence it is a form of remuneration similar to salary and dividends, where funds are withdrawn from the corporation, albeit temporarily.

What is a Shareholder Loan

A shareholder loan is also known as a “draw” or “due from shareholder” transaction because the shareholder loan amount is due from the shareholder to the company in the future.

Under the Income Tax Act, as it relates to shareholder loans, a shareholder may take a loan from the corporation and is not required to report it as personal income on their personal tax return for that fiscal tax year.  A loan to a shareholder must be returned to the corporation by the end of the next fiscal year to ensure that the amount will not be taxed. For the loan not to be considered income, according to the CRA, interest must be charged by the corporation at a prescribed rate to any shareholder loan amount.  It is vital that all loans are properly documented in a written agreement, and or documented as a corporate resolution that defines the terms of repayment to the corporation.

For example, Mark has a corporation with a year-end of December 31, 2020.  Mark may withdraw a shareholder loan from the corporation at any time in 2020 and not have to report it as personal income, as long as he returns the shareholder loan by December 31, 2021.  Therefore, if Mark borrowed $50,000 from his corporation in January 2020, he will not need to report it as personal income in 2020.  However, he will still be required to return the shareholder loan plus prescribed rate interest (currently at one percent), thus Mark will need to return $50,500 (Principal + $50,000 x 1%) by December 2021.  This allowed Mark to borrow money from his own corporation for nearly two entire years at a minimal interest rate.

Interest Rate Changes

The Shareholder Loan interest rates are determined by the Federal Government of Canada, more specifically the Canada Revenue Agency (CRA) on a  quarterly cadence.  Below you can see any changes made to the Shareholder Loan interest rates from 2009-2020:   

  • From April 1, 2009, until March 31, 2018, The Shareholder Loan interest rate was 1% 
  • As of July 1, 2020, the Shareholder Loan interest rate was cut back to 1% as the world continues to try and circumvent the adverse economic effects of the on-going Covid-19 Pandemic

For more information on Shareholder Loan interest rates and to view the historical Shareholder Interest rates set by the Canada Revenue Agency (CRA) visit the following CRA Website

Benefits of a Shareholder Loan

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. Also, it is imperative that your loan meets one of the following conditions to avoid a costly or unintended tax consequence. 

Shareholder Loan Conditions

  • The shareholder 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 shareholder 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 shareholder 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, 2019, would have to be repaid by December 31, 2020.**

* 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 is 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, 2020, 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 2020).

Other Shareholder Loan Tax Tips

Any loan to a shareholder that does not meet one of the conditions above is included in the shareholder’s income and no expense is allowed to be deducted by the corporation, resulting in double taxation.  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!  Our Chartered Accountants at SRJCA can help your corporation by passing on vital tax savings through proper tax planning initiatives as we are doing with thousands of corporate and personal clients every year.

As mentioned above, ensuring that you are not being penalized by the Canada Revenue Agency (CRA) for improperly withdrawing a Shareholder Loan is critical within your personal and corporate income tax planning.  In the worst-case scenario, the Canada Revenue Agency (CRA) can have the full amount of the loan plus interest subsequently added to the shareholders’ income for the year of the loan and not allow a deduction at the corporate level (the way one would normally get for a salary paid).  Nonetheless, planning for repayment within two corporate fiscal year ends is a reliable course of action to mitigate any worry of penalization from the Canada Revenue Agency (CRA).  Having an experienced accounting team in place to not only plan, but to monitor and execute is pivotal when a corporation has transactional deposits into, and withdrawals out of, your corporation.

Employee Loans

Another valuable tax tip is to reward key employees of a corporation with automobile and housing loans.  The Income Tax Act (ITA) explicitly grants corporations the ability to enter into a bona fide loan agreement with its employees in order to acquire a vehicle or a home.  This is a benefit to the corporation in many ways as it creates deeper, more loyal bonds with its employees, and allows them to benefit from minimal interest rates they would not be able to receive at financial institutions or any other lender.  A sense of trust is instilled into both parties, and employees have a sense of gratitude to their employer.  A Shareholder Loan to an employee does have the risk that the loan can be defaulted, however, this risk should be minimal as the owner-operator of the corporation has transparency on his/her payroll, expenses, revenue, and forecasts.  This will allow the owner of the corporation to easily determine what a reasonable loan amount should be.  No matter your risk appetite, always remember to document and sign any agreement of a Shareholder Loan to an employee of your corporation.

A shareholder loan can be very beneficial if your employees are considering buying a home, a car, or are in need of short-term funding. And, if your employees require a loan for a vehicle or house, a Chartered Accountant from SRJCA can definitely help you plan and navigate the steps required to complete agreement and execute an employee Shareholder Loan.   It is important to speak with an accounting professional when planning for a Shareholder Loan to avoid any unnecessary penalties from the CRA that may violate the Income Tax Act (ITA).  If tax planning opportunities arise, they can also be used to create value through tax savings.  As Chartered Accountants in Toronto and Mississauga, we recommend you seek professional advice before contemplating the use of shareholder loans.  Contact a Chartered Accountant for more tax tips by email at info@srjca.com or call us at 647-725-2537 for consultation.

FAQs

What are loans from Shareholders?

A shareholder loan is an agreement to borrow funds from your corporation for a specific purpose.  In essence, it is a form of withdrawing funds from your corporation, similar to salary and dividends, albeit temporarily. A shareholder loan can be very beneficial if you are considering buying a home, a car, or are in need of short-term funding. 

How do Shareholder loans work?

Shareholders may take a loan from the corporation and are not required to report it as personal income on their personal tax return for that fiscal tax year.  A loan to a shareholder must be returned to the corporation by the end of the next fiscal year to ensure that the amount will not be taxed.  Interest is payable on shareholder loans at the prescribed rate of interest in effect with the CRA at the time.  It is vital that all loans are properly documented in a written agreement, and or documented as a corporate resolution that defines the terms of repayment to the corporation.

Can loans to shareholders be considered as income?

If not structured properly, there is a risk a shareholder loan may be considered as income to a shareholder. It is imperative that any shareholder loans meet the repayment guidelines, or are for appropriate uses in the shareholder’s capacity as an employee. All loans should be properly documented and have written agreements in place.