A corporation is a separate legal entity. This means a corporation is considered another "person" taxable under the income tax act. As such, the way you transact with a corporation in which you are the owner/shareholder may have tax consequences on your personal side without you even knowing. That is why it is important that you are aware of the potential impact of transferring funds in and out of your company may have on you. In our experience, we have seen many instances where shareholders/owners withdraw funds and don’t structure transactions appropriately that lead to negative tax consequences.
There are three ways in which a shareholder can withdraw funds from their corporation:
3) Loan Repayment (when shareholder has put in initial capital in the business)
Generally funds transferring between the shareholder and their business will fall under those three buckets. Salary and dividends to the shareholder will result in personal taxes; however, a loan repayment does not result in personal taxes for the shareholder. It is a return of capital.
As technology accountants, a common issue we see with new clients is the treatment of funding from investors for their business. For instance, an entrepreneur who has been marketing to raise capital may receive funding personally by the investor; it is not a good idea to have the funds transferred directly to the newly incorporated company from a tax standpoint. The funds should be deposited personally and then transferred to the company as a shareholder loan to the company from the shareholder. This is beneficial as when you draw funds from the start up once it starts generating income, you will be able to draw funds as a loan repayment. If this was not done, when the shareholder withdraws funds, there is risk of the funds being withdrawn to be considered a dividend or a loan from the company to the shareholder.
Another common issue start up companies are not aware of is when they have a balance owing to their company (i.e., a loan from the company to the shareholder). If the balance is outstanding on the company balance sheet for more than a year, there could be an income inclusion for the shareholder on their personal tax side.
When transacting with your company and transferring your funds between you and your company, it is important to know what bucket those transaction fall under as noted above (i.e., salary, dividend, loan repayment). Once you understand the nature, you can avoid running into issues. To help prevent potential problems, there should be a loan agreement drafted between the investor and the shareholder personally and between the shareholder and their company. Many a times, the loan agreement with adequate interest rate will protect the shareholder from an adverse tax consideration by the CRA in the event of an audit.
Therefore, we advise business owners and start up tech companies to try to understand that the corporation is a separate entity from you. There are generally three ways to withdraw funds from the company (salary, dividend, loan repayment). And it is imperative to have loan agreements in place when you are loaning funds to the company, etc. For more guidance on transacting with your company, feel free to contact MP Group.