Many taxpayers, especially business owners, areShareholder Loans terrified of being audited by CRA. The internet has many blogs from individuals and professionals speculating on what causes one to get audited and how you can avoid it.

It is true that certain behaviours on the part of the taxpayer can trigger an audit. One of the most dangerous as it relates to those who are incorporated is shareholder loans.

Here is how it happens.  We know that many of you will relate because this is exactly what we see constantly from clients whose actions (often with their accountant’s ‘help’) have led to an audit.

And who ever heard of good news coming from a tax audit!

1. John and Mary quit their jobs. As a hard working couple they have saved a little money and based on the good work they did as employees working on customer jobs (they are both plumbers) they believe they have enough referrals to triple their income by being self-employed.

2. Not being naïve, they know that they know their trades but nothing much about business. They have seen their friends go bankrupt and they do not want that!  So they ask around and meet an accountant. In fact, they interview two accountants. Both told them that for personal liability reasons they should incorporate. Both accountants helped them estimate their cash flow and asked them what they needed for personal cost of living.

3. That was all good, but accountant #1 told them to keep it simple and go onto payroll from their own company and pay the taxes every month. So they chose accountant #2. He ‘won’ the competition because he told John and Mary how they can “pay no tax in year one”.  Wow! “We will be able to buy more tools, take a vacation, advertise more, etc. etc.” think John and Mary.  “We have found a very smart accountant.”

4. The business starts to go quite well. They are working every day and they are exhausted from all the tasks that come from running their own business and doing the work.  The good skills they had when they saved the money? Gone in the flurry of long days and Sunday emergency calls.  No worries!  John and Mary have never seen so much money in their lives.  Suppliers have given them terms.  GST/HST is only due every 3 months.  The bank sends them increased credit limits (lots of business expenses have been going through the credit cards which they pay off most of the time based on when customers pay them).

5. John and Mary put receipts in a special accordion file (now bursting and spilling onto the desk). They continue to say they will catch up the bookkeeping and enter everything into QuickBooks tomorrow – which is just as hectic as today so that never comes around.

6. They take a vacation, buy a snowmobile and a new motor for the boat. They are eating out a lot. Some unusual expenses occur. No problem!  There is a lot of money in the business bank account.

7. These are not negligent people and 4 months after accountant #2 calls then to ask where the books are they get them all together and send them over. Accountant #2 rolls his eyes at the mess but gets his bookkeeper to straighten the books out.

8. Accountant #2 calls John and Mary in for a meeting. Here is what he tells them: “You owe GST/HST for two filing periods, we are missing receipts for many job-related expenses and tied only some of them into the credit card statements. You owe payroll taxes for the two apprentice plumbers and WSIB premiums. The company owes corporate income taxes but that is at the low rate of just 16% (“wow” think John and Mary, “we paid closer to 40% when we worked on jobs”).”  Feeling quite content (and just a tiny bit worried that they do not really know what this is all about) they have no real worries. The company bank account gets emptied and pays this all up to date.

9. In fact when the accountant shows these good plumbers the company balance sheet they see $110,000 as an asset! What is that they ask?  Accountant #2 tells them that they have drawn $110,000 personally from the company but do not have to pay tax on it this year.  So John and Mary go happily into year #2 not knowing what is about to happen.

10. Year #2 is not quite as good on the business front. They lost one big account and had a bad debt to write off.  They spent another $120,000 personally – all just charged through the business account.

11. At the end of year #2 accountant #2 does the financials and books. He tells them the company owes corporate taxes again and because they did not pay quarterly installments there are interest and penalty consequences. They also have personal taxes to pay on year #1 to the tune of $110,000 – but he has done income splitting between them and “all” they have to pay is (combined) $27,000.  Lucky them – he declared a dividend for them to clear the $110,000 they owed the company from year #1 money spent personally.

12. Clunk! Their hearts drop. They quickly figure out how to tighten the belt and pay this off over the year at just over $2,000 per month. But wait, we have to pay company tax instalments so the belt gets a little tighter – another $1,500 per month cash needed.  And it gets impossibly tight when they are told they need to pay personal tax installments quarterly on their year #3 income during year #2 (that is, while they are paying year #2 personal taxes).

13. Worse still, the only source of money is the company and to get the money for personal taxes out they have to increase what they take out of the company. This drives up their tax rates and creates a bigger hole in their financial lives.

14. Confused? Well, to professional accountants it is simple: they are experts at spreadsheets and planning. However, to professional plumbers it is a recipe for disaster.

Why not just follow the KISS principle?  Pay your taxes as you take the money.  Know that what you are spending is tax paid money and you are free to spend it.  Keep your business and personal financial lives separate.

That is what accountant #1 tried to tell them, but the urban myths about how the rich people and their accountants “know things” abound and John and Mary wanted some of that too.  Accountant #2 sold them on a wish that they would save money. Theoretically he was right.  Practically? He was dead wrong. The savings were only going to be the small benefit of deferring taxes one more year.  And even if accountant #2’s plan had worked, what happens when John and Mary retire and the first year they still have to pay taxes on the bigger income of the previous year?

Outstanding shareholder loans should not be left unattended and if you are in this situation and need help please contact Tax Solutions Canada today by calling 1.888.868.1400.