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What is a Shareholder Loan?

Someone filling out Shareholder Loan Agreement Form.

You may be familiar with shareholder loans if you own your own company or are self-incorporated. However, what are shareholder loans and what is the purpose of them? With the help of this guide, we will address the answers to these and other queries.

Shareholder Loan

A shareholder loan is a financial transaction where a shareholder of a corporation either lends money to the corporation or borrows money from it. This type of loan can be a common way for businesses to manage cash flow and for shareholders to inject or withdraw funds from the company. 

“Shareholders can withdraw corporate funds from their company as a loan and use it for personal use. Alternatively, shareholders can provide their own funds into the company to support operations and expansion.”

  • The company doesn’t have to put up any assets as collateral.
  • There are several ways to arrange shareholder loans. They could be set up like term loans, for instance, with a predetermined repayment schedule. They may also be set up as credit lines that the shareholder can access whenever necessary.
  • If the loan is not repaid within a particular period of time, the loan might be considered a distribution to the shareholder and subject to tax consequences.
  • A shareholder loan can give a business the money it needs to keep going while it is looking for new funding if it is in the process of raising more capital.
  • The interest rate must be at least equal to the prescribed rate set by the Canada Revenue Agency (CRA). This rate changes quarterly.

Advantages & Disadvantages of Shareholder Loans

Advantages:

  • Shareholder loans do not require the same level of underwriting and risk assessment as traditional bank loans, they frequently have a lower cost of capital.
  • If shareholders have a stake in the company’s success, they might be more willing to lend money than a bank, especially at a lower interest rate.
  • The corporation may be able to deduct the interest paid on a shareholder loan from its taxes, which lowers the total cost of borrowing.
  • Shareholder loans can offer greater flexibility in terms of repayment schedules and other terms.

Disadvantages:

  • Shareholder loans can create conflicts of interest between the shareholders and the company.
  • Loans from shareholders may have unfavorable tax consequences for the business and the shareholder.
  • The company’s interest payments may not be tax deductible if the loan is not properly structured, which would result in larger tax obligations.

What are the Tax Benefits of Shareholder Loans?

1. Interest Deduction for the Corporation:

 

  • Tax-Deductible Interest: When the corporation borrows money from a shareholder and pays interest on the loan, the interest expense is generally tax-deductible. This deduction reduces the corporation’s taxable income, effectively lowering its tax liability.
  • Cost of Borrowing: Lowering taxable income through interest deductions can help manage the overall cost of borrowing, making shareholder loans more attractive compared to traditional financing options.
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2. Interest Income for the Shareholder:

 

  • Taxable Interest Income: The interest received by the shareholder is considered taxable income. Depending on the shareholder’s tax situation, this income may be taxed at a lower rate than other forms of income, such as dividends or salary, especially if the shareholder is in a lower tax bracket.
  • Investment Income: The interest income received from the shareholder loan can provide an additional income stream for the shareholder, which can be advantageous from an investment perspective.

 

3. Income Splitting:

 

  • Family Members as Shareholders: In some cases, structuring shareholder loans to benefit family members who are shareholders in the business can facilitate income splitting. By providing loans to family members involved in the business, income can potentially be allocated to members in lower tax brackets, reducing the overall family tax burden.

 

4. Deferral of Income:

 

  • Deferred Taxation: If the shareholder loan is structured and managed correctly, it may allow for the deferral of income taxes on borrowed funds. This means that the income taxes are deferred until the loan is repaid, which can be beneficial for cash flow management and tax planning.
  • Proper Structuring: It’s important to ensure that the loan meets the specific conditions set by tax authorities to qualify for deferral. Compliance with the Canada Revenue Agency (CRA) rules and maintaining proper documentation are critical.

 

5. Tax Efficiency in Distribution:

 

  • Alternative to Dividends: Providing loans to shareholders can be a tax-efficient alternative to paying dividends. Dividends are subject to dividend tax credits but may be taxed at a higher rate compared to interest income from shareholder loans.
  • Flexible Distribution: Shareholder loans offer flexibility in distributing funds to shareholders without triggering immediate tax liabilities that would arise from dividend payments.

 

6. Capital Gains Tax Considerations:

 

  • Shareholder Loans as Advances: If shareholder loans are used as advances to acquire shares in the corporation, any increase in the value of shares over time could result in capital gains when the shares are sold. Capital gains are taxed at a lower rate than regular income, providing potential tax savings.

 

7. Tax-Deferred Draws:

 

  • Borrowing Against Equity: Shareholders can borrow funds against their equity stake in the corporation without incurring immediate tax liabilities, provided the loan meets the regulatory criteria. This method allows shareholders to access funds while potentially deferring tax liabilities until the loan is repaid.

Do shareholder loans have to be repaid?

Yes, shareholder loans generally have to be repaid, but the exact terms of repayment can vary depending on the nature of the loan agreement and the applicable tax regulations.

Within a year, the shareholder is required to repay the loan. The shareholder would be required to report and pay any applicable taxes on the loan if it isn’t repaid within a year.

If interest is assessed on the loan, the corporation will normally pay the shareholder the interest on a regular basis. The loan agreement should contain a clear definition of the terms for paying interest.

Consult Tax Professionals

To manage the complexities and guarantee compliance with tax regulations, tax professionals should be consulted before taking out shareholder loans. A shareholder loan can have major consequences for taxes if it is not structured properly, even though it offers flexibility and possible tax benefits. Their knowledge, advice, and assistance can help you structure shareholder loans wisely, steering clear of possible problems and strengthening your position financially. Collaborating with proficient tax experts is a wise choice for both corporations and shareholders seeking to handle shareholder loans effectively and legally.