One of the primary benefits of incorporating your business is the flexibility to determine a remuneration strategy while deferring taxes on the earnings retained within the corporation. Along with this flexibility comes additional restrictions compared to an unincorporated business. There are many rules in place which prevent shareholders from freely withdrawing funds from the corporation unless it is done in a taxable manner, such as by paying salary or dividends. Amounts withdrawn as shareholder loans are subject to strict requirements.
The general rule with respect to shareholder loans is that the amount will be included in the income of the shareholder in the year of withdrawal. An offsetting deduction is not allowed within the corporation as this is not considered an expense, but rather a benefit conferred on the shareholder. This rule also applies to loans made to individuals who are connected to the shareholder, such as their spouse or children. The shareholder or connected individual will be allowed a deduction in the year of repayment. This general rule prevents shareholders from using funds taxed at the lower corporate rates to pay for their personal expenses.
There are many exceptions to this rule. The most common exception relates to repayments within one year from the end of the year in which the loan is made. For example, if a corporation makes a loan to a shareholder at any time during the fiscal year ending on December 31, 2021, the loan will not be included in the shareholder’s income if it is repaid by the shareholder no later than December 31, 2022. If the loan remains outstanding as of January 1, 2023, the shareholder can be reassessed to include the full amount of the loan in their 2021 income. Income taxes plus interest charges will be assessed at that time.
Loans that are repaid within one year may still be subject to a deemed interest inclusion if interest is not charged on the loan at a reasonable rate. The shareholder will be subject to an interest inclusion at the prescribed rate, which is currently 1%. Interest should be paid by the shareholder to the corporation within 30 days of year-end and this amount should be included in the taxable income of the corporation.
An income inclusion may also apply if a loan is determined to be part of a series of loans or repayments. In the example above with respect to repayments within one year, a shareholder could repay the loan each December 31 and withdraw the funds again on January 1 to avoid an income inclusion. This rule prevents this situation from occurring.
There are various exceptions that relate to loans made to shareholders who are also employees. A loan may be made to employee shareholders who are not “specified employees”. A specified employee is an individual who owns at least 10% of the issued common stock of the corporation. Loans can also be made to employee shareholders or their spouse, including specified employees, to purchase a dwelling to live in, purchase a vehicle to be used in their employment or purchase previously unissued shares in the capital stock of the corporation.
The exceptions above regarding employee shareholders are subject to two conditions. First, the loan must be paid in respect of the individual’s employment rather than their shareholdings. Various factors will be assessed to determine this, including the terms of the loan such as the interest rate and the size of the loan relative to the retained earnings of the corporation. Based on these factors, the benefit received by the employee must be considered part of a reasonable compensation package that would be offered to all employees. Second, there must be bona fide terms to repay the loan within a reasonable timeframe.
Shareholder loans may be subject to scrutiny but are allowed under the right circumstances. It’s always advisable to document the terms of the loan in a valid loan agreement, document the loan in the company’s minute book through a resolution, and to ensure that there are bona fide terms of repayment, including a reasonable timeframe and interest rate.
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