Borrowing Money From Your Own Corporation
Borrowing money from your own corporation allows you to collect more than your normal salary or dividends at a tax-free rate.3 min read
2. Exceptions to the One-Year Limit
3. What Happens if the IRS Investigates?
4. How to Avoid Penalties From the IRS
Updated November 2, 2020:
Borrowing money from your own corporation allows you to collect more than your normal salary or dividends at a tax-free rate. However, you can't just take as much money as you want. You need to follow specific tax rules.
Understanding Shareholder Loans
The first step in borrowing money from your corporation is to record the amount in your books as a shareholder loan. A shareholder loan must be paid back within a year of the corporation's year-end. Otherwise, the money will be added to your personal taxable income, meaning you'll have to include it when filing your taxes.
An example of this is if you borrowed $10,000 from your company in 2012. If your company's year ended on December 31, 2012, you would have until December 31, 2013, to pay back your loan. If for some reason you were unable to, the amount you borrowed would be added to your personal income for 2012.
Therefore, as long as you time your borrowing right, you can avoid paying the money back for more than a year. Just be careful not to pay off the shareholder loan with another loan. This can put your personal income at risk.
Exceptions to the One-Year Limit
Thanks to the Income Tax Act, there are a few exceptions to the one-year limit for borrowing money from your corporation. These include using the loan to buy:
- A home for personal use.
- Shares of the corporation.
- A car used for work purposes.
- Items directly from the business via trade debt.
Of course, these need to be legitimate purchases. You cannot just lie and say you are buying these items and then use the money for something else. Additionally, you will still be charged interest at a predetermined rate.
One other important factor is that the loan must be provided to you as part of your employment, not because you're a shareholder. This means that other, non-shareholder employees should have access to these same types of loans. Of course, this can become tricky if you are in charge of a single owner-managed business where you have only ever paid yourself dividends.
What Happens if the IRS Investigates?
In many cases, the IRS will audit your return once they notice you have taken out a shareholder loan. They will be looking to see if you are trying to disguise your wages or a dividend. That is why you should always be cognizant of when the IRS may look at your return so you can structure your loan appropriately. The process typically goes like this:
- The IRS will investigate your relationship to the organization. If you are the company's only shareholder and completely control your earnings, that definitely weakens your argument that the loan is valid. The IRS will be less likely to question your loan if you are one of several shareholders in the company (and the only one who has received such a loan).
- After this, the IRS will investigate the details of the loan. Generally, the more businesslike the loan appears, the less the IRS will poke around. They check to see if:
- You signed a formal promissory note.
- You pledged security against the loan.
- You are paying interest.
- You set a maturity date or repayment schedule for the loan.
- You have missed any repayments.
- Your company has tried to collect any overdue funds.
- There are a few other questions the IRS will ask to further prove your loan is genuine:
- Are you receiving a salary that is standard for work in your industry?
- Is the loan you've taken out repayable based on your salary?
- Are you receiving dividends from your company?
- Is the loan comparable to the profits the company is making?
After looking at these factors, the IRS does have the ability to reclassify your loan as a distribution or dividend if they see fit. If this happens, the loan will not be deductible for your corporation.
How to Avoid Penalties From the IRS
As long as you observe specific formalities when taking out your loan, the IRS should not penalize you with the distribution or dividend treatment. You'll want to:
- Document the withdrawal as a loan and create a promissory note.
- Set interest at the federal rate and provide collateral if necessary.
- Record the transaction on your company's books.
- Repay in accordance with the guidelines set by the promissory note.
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