As a business owner, you work hard to build your business. So what’s the harm in rewarding yourself by allocating some of that hard-earned money to renovate your house? From a tax perspective, if your business is unincorporated, you can do this so long as you don’t have financing or any other obligations restricting the use of funds from your business account. But this “mingling” action becomes more of an issue when your business is incorporated.

So why incorporate? Simple, a corporation is a great vehicle for shielding liability. As a separate legal entity, however, any funds withdrawn from the corporation are subject to tax in the shareholder’s (read, business owner’s) hands. Shareholders often get into trouble when they withdraw funds for personal use and then don’t pay tax on it—or don’t repay the principal to the company.

Taxable Benefit

Consider the case of Ryan Smith, who incorporated his company shortly after he invented and patented a unique building product. When he decided to renovate his home, rather than personally borrowing money from the bank at a higher rate, he withdrew money from his corporation’s bank account. The amount was reflected as a loan receivable on the balance sheet and was never repaid.

Smith now has a problem. The Income Tax Act considers amounts loaned to shareholders as income in the year of withdrawal; unless the money is repaid within a set timeframe. In Smith’s case, the Canada Revenue Agency (CRA) assesses him for unpaid taxes for the year he withdrew the money and he will have to pay interest and penalties. The CRA will also regard the value of the interest Smith didn’t pay as income and tax him on it.

Smith can address this is by voluntarily disclosing his actions to the CRA, which can use its discretion to waive a portion of the interest and penalties, but not the taxes. And, if Smith repays the loan now, he can also qualify for a deduction from his current year taxable income, provided the repayment is not part of a series of loans and repayments.

This article was originally published for Canadian Capital on April 20, 2011. Read the original article here.

Stella Gasparro, CA is a Taxation Services Partner with Meyers Norris Penny LLP in Markham.

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