Big Problems with Shareholder Benefits
Many small and medium sized businesses are incorporated. And most of those incorporated businesses are owned by one person, one family or a small group of owners. We call these closely-held private companies.
When the Canada Revenue Agency audits a closely-held private company, they pay particular attention to transactions involving the shareholders or the families of the shareholders. They are looking for transactions where the company has paid personal expenses on behalf of the shareholders (or their families) or where money in the company or property owned by the company ends up in the hands of a shareholder (or a family member).
There is nothing necessarily wrong with having your company pay personal expenses and it is normal for a company to make payments or transfers to its shareholders.
The issue is whether or not those transactions are properly recorded in the accounting records of the company and properly accounted for on the company’s tax return and the individual shareholder’s personal tax return.
Money or property of a company can really only come out of the company into the hands of a shareholder in one of the following ways:
1. Salary and benefits;
3. Loans or advances to the shareholder (shareholder loans).
The first two above are usually well documented and require tax slips to be issued each year.
Shareholder loans can be trickier and, in many cases, are poorly documented. Mistakes and omissions are common.
One of the problems is that many shareholders treat their company as if it is their personal bank account. So if there is money in the company, they will use that money to pay both business expenses and personal expenses.
Business expenses are a deduction for a company. Personal expenses are not deductible.
Sometimes it isn’t clear to the bookkeeper if it’s a business expense or a personal expense so it is entered incorrectly. Sometimes it is a combination of business expense and personal expenses (e.g. travel). So it can be confusing. In a typical Notice to Reader engagement, the company’s accountant may not be able to detect the error.
In addition, personal expenses paid by the company need to be treated as a payment to a shareholder. So not only are they not deductible, but they must also be treated as either
1. salary and benefits (e.g. a company car),
2. dividends or
3. a charge to the shareholder loan account (a debit to the shareholder loan account).
Cash transfers to a shareholder are easier for accountants to spot. Payments of personal expenses and non-cash transfers are much more difficult to detect.
For example, a problem can arise when an asset owned by the company is transferred or sold to a shareholder (or a family member). Such transactions are typically called “non-arm’s length” transactions and must be recorded at the current fair market value. If they are properly recorded, they are treated as if the asset is sold to the shareholder at its fair market value. However, some company’s choose to record these transactions at a price that is under the prevailing fair market value or they aren’t recorded at all.
For example, suppose a property development company builds 50 homes to sell for $400,000 each. Suppose that the total expenses work out to be $250,000 for each home. Now the shareholder decides to transfer one of the homes to his daughter. The company records the transfer as a sale at cost ($250,000). The Canada Revenue Agency’s position is that the company should be reporting this as a sale at $350,000 (with a $100,000 profit) plus HST and the daughter should be paying the company $350,000 plus HST.
If this is not reported, the Canada Revenue Agency will assess the company for the additional unreported profit of $100,000, the unremitted HST and will also assess the shareholder for the $350,000 as a shareholder benefit (less anything the daughter has actually paid to the company).
Or suppose a company constructs a building on the shareholder’s personally owned property. Although this building is used for the business of the company, unless it is properly documented, that building attaches to the land and therefore has added to the value of the land which is personally owned by the shareholder. The Canada Revenue Agency will treat this as conferral of a personal benefit under subsection 15(1) of the Income Tax Act and will tax the shareholder on the value of that benefit.
We deal with these kinds of tax assessments all the time. Although in a few cases they are deliberate, the vast majority of them are done unintentionally.
The best strategy is to record these transactions properly and put the supporting legal documentation in place. However, if that is not done and is detected in the course of an audit, we will need to appeal the assessment and use the case law to attempt to minimize or eliminate the taxes owing, especially if the error was unintentional.