The Taxing Task of Getting Money Out of a Corporation
Oft-times entrepreneurs choose to conduct business through an incorporated company, which creates a new and separate legal entity in the eyes of the Tax Department (CRA). Any profits it makes belong to the company and only indirectly to the shareholder. Any money withdrawn from the company by the shareholder needs to be classified in some fashion for tax purposes. Some of these classifications allow money to flow out tax-free whereas others require the entrepreneur to pay personal tax on the cash flow.
The most routine tax-free source is “repayment of shareholder loans”. If the shareholder has previously advanced tax-paid money to the corporation, that may be taken back tax-free. However, if the shareholder has never needed to lend to the company in the first place, there isn’t money to be paid back!
Another source of tax-free money is more esoteric – capital dividends. This source only arises where the corporation itself has entered into some business transactions which resulted in capital gains. This area is less common and requires some professional tax advice. See the article titled Corporate Capital Dividend Accounts for more information.
Lastly, there may exist other tax-free money in the form of share redemptions. Again, this source is less common and requires professional tax advice.
There are many taxable sources of cash flow for an entrepreneur. While many of them have different terminologies, they get to the same tax result. A number of these fall under the classification of employment income, meaning that the entrepreneur is an employee of his/her company. These include, for instance: salaries, wages, bonuses, commissions and directors’ fees.
Alternately, an entrepreneur may withdraw money as a shareholder rather than an employee. In this case, the cash flow is termed a dividend. This lowers the personal tax because dividends come with a tax credit which lowers the personal tax cost by approx 20%, in recognition of the tax on profits already paid by the corporation.
Any withdrawals by the entrepreneur that have not been classified as any of the above fall into the category “shareholder appropriations”, which show up on the company financial statement as an “advance to shareholder”. These fall into Section 15 of the Income Tax Act, which itself has two sub-categories: subsections (1) and (2).
Subsection (2) is more benign. Subsection (2.6) allows the loan to exist as long as it is repaid within one year from the end of the fiscal year in which the loan is advanced. Interest must be paid by the shareholder or else received as a taxable benefit for the duration of the time outstanding. Also, the loan ought not to be part of a series of advances and repayments.
Failing this repayment schedule, subsection (2) requires the amount to be taken into personal income retroactively to the year withdrawn. The inclusion does not count as “earned” for RRSP eligibility. The amount is not deductible to the corporation. This is not a good result because personal taxation has occurred without a corresponding corporate tax deduction. In this case, the interest assessed in the previous paragraph is withdrawn. Section 20 (1) (j) allows that personal income inclusion to be offset with a deduction in a subsequent year if the loan is then repaid. While this may not seem practical to the entrepreneur, what can happen is that extra taxable compensation can be given that year to provide the funding for the repayment. This extra compensation is now deductible to the corporation, and the extra personal tax is offset by the Section 20(1) (j) deduction.
When the corporate funds have been advanced to an individual who is not at arm’s length with the shareholder, then the same rules apply but they apply to the individual not the shareholder. See the article Financing Higher Education: Children of Entrepreneurs for more information.
Subsection (2.4) allows these loans to a shareholder (or his or her spouse) to exist as long as the funds were taken to acquire either a family home, an automobile that was required to be used for work or more shares in the company. The family home need not be the family principal residence, i.e. it may be a second property like a cottage. The loan cannot be made to repay the mortgage on a pre-existing home. Further conditions include that the loan bears interest at at-least the government prescribed rate for borrowing and the loan is paid back on normal commercial terms commensurate with the nature of the loan.
The first two of these would seem to be very valuable. However, a few years ago, CRA tightened this subsection by indicating that a company cannot preferentially play lender to select employees, ie the shareholder. It is unlikely that the company wishes to open its cheque book to all of its employees who could use assistance with purchasing a house or vehicle. The third option also is not particularly useful, as there are few situations where a shareholder needs to borrow money for the company for the express purpose of infusing back into the company as share capital.
Subsection (1) is the one that must be studiously avoided. It is a draconian “big stick” that CRA has in its arsenal to punish aggressive tax-filers. Subsection (1) usually results from an audit where CRA has uncovered payments to the shareholder which were neither classified as any of the afore-mentioned payments nor legitimate company expenses. In effect, these payments were for personal expenditures. An entrepreneur can fall into this subsection, not just from oversight or mal-intent, but also from disagreement with CRA as to whether an outlay is a legitimate company expense, e.g. were business meals or business travel in fact for business or were they personal? Subsection 15(1) causes these amounts to be added to the individual’s personal tax return for the year received BUT the payments are not allowed as a deduction to the company. Also, unlike the working of Subsection (2), the income inclusion under Subsection (1) cannot be undone by a subsequent repayment by the shareholder.
Section 15 does not apply to funds lent between corporations, both of which, for instance, may be owned by the same shareholder.
On a more positive note, entrepreneurs should ensure that their compensation strategies make appropriate use of various other means to withdraw funds tax-free from their corporations. For instance, an employee-owned car used for business permits a reimbursement at generous per-kilometer rates. Also, it may be wise to establish a private health services plan in the company to cover the health care costs of the entrepreneur’s family. Lastly, a home office reimbursement may be permitted for a legitimate business office space maintained in the family home.