Why is your tax bill so big? Have you considered your shareholder loan?
In this article, I break down the importance of a shareholder loan, so you don’t unintentionally screw yourself.
Every tax season I hear moans, groans, and gasps from taxpayers about their tax bills.
As a Chartered Professional Accountant (CPA) I know a big cause of this is the misconceptions around corporation taxes and 'shareholder loan' accounts.
Let's go through the basics so you can be well informed.
What the Heck is a Shareholder Loan?
At its most basic, a shareholder loan is an account in your bookkeeping records.
It tracks contributions and withdrawals from your corporate bank account.
Let’s go through a few examples so we can understand what this looks like.
Jennifer recently incorporated and to get her budding new business off the ground she deposited $10,000 into her corporate bank account to handle upcoming expenses.
This meant Jennifer created a $10,000 shareholder loan.
Her corporation now owes her $10,000. Jennifer can withdraw these funds from her corporation at any point, tax-free.
In this instance, Jennifer’s shareholder loan is benefiting her tax situation because it allows flexibility on the tax treatment of her cash withdrawals.
"At its most basic, a shareholder loan is an account in your bookkeeping records. It tracks contributions and withdrawals from your corporate bank account." – Jillian Battaglio, CPA, CA
After a few years Jennifer’s business has really picked up steam and she’s created a healthy reserve of cash in her corporate bank account.
Jennifer decides to take $10,000 of cash out of the company as repayment for her initial investment. Jennifer also decides to go on a lovely and well-deserved personal vacation to celebrate her success. She charges the $5,000 trip to her corporate bank account.
Jennifer’s shareholder loan is now overdrawn by $5,000. In other words, Jennifer owes her corporation $5,000.
This can be problematic for Jennifer because the Canada Revenue Agency (CRA) requires that all overdrawn shareholder accounts be ‘repaid’ within 1 fiscal year.
This means that an overdrawn shareholder loan cannot appear on your corporate tax return 2 years in a row. Luckily you have a few options to eliminate the loan.
How To Reduce Your Shareholder Loan
1. The first option to reduce your shareholder loan is to physically repay the money.
Jennifer could take $5,000 out of her personal bank account and deposit it into the corporation’s bank account to clear her overdrawn shareholder account.
Despite being a great option with no negative tax consequences, the repayment method isn’t the first choice for most business owners.
2. The second option is to take the overdrawn balance into personal income.
Rather than repaying the $5,000 Jennifer could take a non-cash $5,000 salary or dividend from her corporation.
To have this option work Jennifer won’t physically take the cash because she’s already done so by charging the $5,000 vacation to her corporate bank account.
Instead, this is an accounting adjustment and Jennifer will issue a T4 wage statement or T5 dividend statement from her company which she will include on her personal income tax return and pay personal taxes on.
What if You Don't Want To Deal
If you decide you don’t want to clear up your overdrawn shareholder account things can get a little messy with the CRA.
The first year you leave the overdrawn account CRA requires you to charge ‘imputed interest’ to yourself.
This means your corporation must record interest income at rates pre-determined by the CRA.
Your corporation must then pay taxes on this imaginary interest.
You also experience a slight increase in your overdrawn shareholder loan account because CRA expects you to consider this interest as money owed to the corporation.
The second year you leave the overdrawn account things get really nasty.
The CRA can designate the overdrawn balance as a ‘shareholder benefit’.
This means they allocate it to your personal income. What the CRA denies is a deduction from your corporation along with any tax credits you would normally experience on T4 wages or T5 dividends.
Essentially this results in double taxation.
"The second year you leave the overdrawn account things get really nasty." – Jillian Battaglio, CPA, CA
As a warning: housing loans taken by shareholders can also be subject to shareholder benefit risks and can attract double taxation.
Only in instances where a housing loan is available to other third-party employees might this be allowed by the CRA.
Shareholders who set up ‘housing loans’ often end up paying huge tax bills – sometimes up to 50% of the value of the loan taken.
This can take years to repay and it ruins businesses and marriages.
Don't Get Caught Unaware
Understanding how your shareholder loan account works is one of the best ways to avoid surprise tax bills.
Please heed this warning.
Many clients get in trouble with this.
Not understanding the importance of their shareholder loan has landed many with surprise tax bills that can be astronomical.
This is devastating and can ruin marriages and bankrupt businesses. A client of mine sold their company and personal residence just to pay their tax bill.
If you do decide to overdraw your shareholder loan account keep a few planning tips in mind.
Set up regular payroll for yourself rather than haphazardly drawing out cash. This provides stability for personal budgeting and often reduces financial stress. Because of its benefits, it is a strategy I personally employ with my business finances.
If you anticipate having a big personal tax bill, set funds aside. Saving 20-30% can help cover that upcoming tax bill and means you’ll be well prepared.
All right, that is all I have for today on shareholder loans. I hope this article has helped you avoid surprise tax bills.