It is not unusual for a shareholder of a corporation to use company funds to cover personal expenses, particularly in the case of small, owner-managed businesses.
The shareholder may have viewed such a withdrawal as being one of a number of potential things, such as a loan, a loan repayment, a taxable benefit, or the payment of a dividend or salary – or may simply have used the money without paying attention to the form in which it was being extracted.
The tax implications of shareholder corporate withdrawals are typically determined by how the withdrawal is recorded in the company’s books and eventually reported on personal and corporate tax returns.
For instance, a company is permitted to lend corporate funds to its shareholders. To maintain track of the amount owed by the shareholder, the loan would need be recorded in the company’s “shareholder loan account.”
No tax would be due by the shareholder on the loan as long as the loan is paid back to the corporation by the end of the year after the year of the loan.
However, the loan amount would be treated as taxable income that belongs to the shareholder if it is still outstanding after this period. Only when the loan is eventually repaid would the shareholder qualify for a tax deduction to reverse this taxable income inclusion.
Where a shareholder takes an amount out of a corporation, and to the extent that this is not recorded as a loan in the shareholder loan account, the withdrawal may be considered taxable income in the shareholder’s hands immediately.
Therefore, it is essential to record the corporation’s and the shareholder’s intentions at the time of any shareholder withdrawals.
The Kumar case (2024 TCC 105) serves as a recent example of how important it is to accurately record these types of withdrawals.
In Kumar, the taxpayer, now in his 70s, had remortgaged his home on two separate occasions in order to start an automotive business to assist with his son’s career development – the son was a qualified auto mechanic and the intention was that he would operate the automotive business through a new company that Mr. Kumar incorporated.
In 2013 and 2014 the corporation paid over $40,000 to the taxpayer. Mr. Kumar testified that these amounts were repayments of loans he made to the company to set it up and fund its operations.
However, the company’s shareholder loan account was not updated to record these repayments. Therefore, the CRA reassessed Mr. Kumar’s 2013 and 2014 tax years on the basis that the amounts paid by the company were shareholder benefits, rather than repayments of his loan to the company.
Mr. Kumar had prepared the company’s tax returns. He had taken a tax course previously but had no corporate tax training and admitted that he didn’t know how to correctly record shareholder loan repayments on the corporate side. However, he asserted that the amounts received were shareholder loan repayments.
Although the Tax Court judged found that the taxpayer was a credible witness, this wasn’t enough to have the payments classified as shareholder loan repayments as there were no entries in the shareholder loan account recording this.
The Court commented that “to be recognized as shareholder loan repayments, the payments ought to be recorded by the payer corporation as such” and that “the subjective intent of the taxpayer, expressed after the fact, is at best of little relevance”.
Although the court accepted that “one off” omissions from the shareholder loan account may sometimes be corrected after the fact, a long-running practice of not recording transactions in the shareholder loan account could not be.
The court concluded that “the choice is to pay for professional assistance to have the corporate records correctly maintained or to learn how to do it oneself. Mr. Kumar elected neither option.”
The Tax Court upheld the CRA’s reassessment of these amounts as taxable income inclusions, rather than shareholder loan repayments.
The unfortunate result for the taxpayer in Kumar serves as a good lesson for business owners. Where shareholder loans are made to, or received by, a company, the correct recording of these transactions is crucial in order to avoid a nasty tax surprise.