Entrepreneurs need to always keep business and personal finances separate. A corporation is a separate legal entity, and corporate revenues, expenses, assets and liabilities need to be properly segregated. Even if there is only one shareholder of a corporation, there are still two separate entities―the entrepreneur (person) and the corporation. Avoid common accounting mistakes and ensure you manage your business and personal finances separately.
Keeping business and personal finance separate: Tips to avoid common accounting mistakes
A corporation should have its own bank accounts. All transactions, cash receipts and disbursements should go through this account and not an entrepreneur’s personal account.
A shareholder may in the course of running the business make purchases or pay expenses with their own money on behalf of the corporation (especially when the corporation is initially being formed and is not generating sufficient cash flow). Where this occurs all receipts must be kept and disclosed as these are tax-deductible expenses of the corporation.
The corporation will then owe the full amount back to the shareholder (tax-free). Essentially, if these expenses are forgotten, you will end up paying additional tax for both the corporation and personally. This is because these will not be deducted from your taxable income in the corporation, and when you take money out of the corporation, you will be taxed on it rather than receiving it as a draw (discussed below).
For simplicity, it is recommended that instead of paying the expenses out of personal money, an entrepreneur make a loan to the corporation so the corporation can pay the expenses itself. This is preventative rather than reactive.
What if you need money personally?
There are three main ways for an entrepreneur to take money out of the corporation for personal use:
- Salary: Corporations can pay the shareholder a salary. The salary must be reasonable and based on value of services provided. The corporation must withhold and remit to Canada Revenue Agency the applicable payroll deductions. The corporation deducts the salary and the shareholder must pay personal income taxes on it.
- Dividends: Corporations can also pay dividends to specific classes of shareholders in proportionate amounts to the shares owned. Dividends are paid out of after-tax income and are not expenses to the corporation, although the shareholder will receive a dividend tax credit, which in theory exactly offsets the amount of tax already paid by the corporation to avoid any double taxation. The corporation will not withhold any taxes from these amounts, but the shareholder is ultimately responsible for paying tax on them personally when they file their tax return.
- Draws on loans to corporation: If a shareholder loans money to the corporation or pays corporate expenses personally, these amounts become a loan to the corporation and can be taken back tax-free.
Personal property used in the business
If the shareholder owns any capital property (e.g., a building, a car, a trademark or patent) that is used in the business, the corporation will have to account for use of this property. This can be done in three basic ways:
- Rent, royalties, licensing fees: Corporations can pay fees to the shareholder at fair market value for the use of this asset. Under this method, the fees paid by the corporation will be a deductible expense of the corporation. However, they will be taxable to the shareholder personally, and this may not be optimal if the shareholder is in a high tax bracket.
- Sell: Shareholders can sell the asset to the business at fair market value. The corporation will pay or create a loan payable to the shareholder for the fair market value of the asset at the time of the sale. Any future appreciation or depreciation of the asset will belong to the corporation. When the property is sold to the corporation, the shareholder may be subject to capital gains tax if the value at the time of sale was higher than the original cost to the shareholder.
- Rollover: Shareholders can transfer the asset at cost to the corporation in return for additional shares of the corporation. In essence the asset is transferred to the corporation at the shareholder’s tax cost, meaning that any capital gain will not be taxed at the time of the transfer. In return, the shareholder must take a certain portion of shares in the company in the exchange. These shares may be redeemed for cash at a later date. Only when redeemed will they be taxable in the form of deemed dividends to the shareholder.