When pulling money from a corporation for personal use, many business owners will pay themselves a salary or dividend. There is, however, another tactic that many have used over the years to pay themselves money from the corporation, with mixed results, and that is using a loan.
When you receive a loan, it is generally not taxable so it seems like a smart way to “work” the system.
The problem is, the government has seen the loophole and has set up systems to stop taxpayers from taking advantage of this situation. These rules also stop employees from gaining benefits through advances from the corporation.
Firstly, if you are a shareholder of a corporation and receive an advance or loan, the amount may be included in taxable income. The same applies if you are connected to a shareholder or are a member of a partnership or beneficiary of a trust that is a shareholder.
There are a few exceptions to this first rule.
- The debt arose in the ordinary course of the creditor or lender’s business and there are arrangements made for repayment within a reasonable time.
- The loan or advance was made to a taxpayer in their capacity as an employee and they hold less than 10% of any class of share (not a specified employee).
- The loan or advance was made to a taxpayer in their capacity as an employee and was used to acquire a dwelling, treasury share or motor vehicle.
- The loan is repaid one year-end after the loan was made and was not part of a series of loans and repayments. (i.e. you don’t pay back the loan and then immediately borrow it again).
If you include the loan amount in your income and then later repay the loan, you can deduct the amount of repayment from your income in the year the repayment is made. Again, if you repay a loan and then subsequently reloan the money, this deduction will not apply.
If you receive a loan and then any amount of it is forgiven, the forgiven amount will be included in income for tax purposes.
If the first rule does not apply, shareholders and employees who receive a loan or advance may be required to pay personal tax on a taxable benefit for interest on the loan.
This taxable benefit is calculated by applying a prescribed rate to the principal balance. The amount is then reduced by any interest payments or reimbursements made within 30 days after the year end.
The prescribed rate is adjusted quarterly based on the average rate of a 90 day treasury bill. In 2022, the prescribed rate increased from 1 to 3% making loans from a corporation more expensive.
If the proceeds of a loan are used for income-earning, then you may be eligible for a deduction to offset the taxable benefit.
Needless to say, these rules will reduce or eliminate any tax advantages sought by taking out a loan instead of receiving a salary or dividends.
To be sure you are properly managing corporate distribution of funds to shareholders and employees, as well as loans, please contact us today.
