Alice and Brian Thompson are new clients, and this was the first year I had worked on their tax returns. After I reviewed their tax slips and made my notes, I noticed that the most recent financial st...
Alice and Brian Thompson are new clients, and this was the first year I had worked on their tax returns. After I reviewed their tax slips and made my notes, I noticed that the most recent financial statement of their company — Thompson Engineering — showed a large loan payable to a related party.
“What’s this about?” I asked.
“I loaned $10,000 to the company this year,” Alice said
“But the financial statements show loans of $110,000,” I said.
“That’s right,” Alice replied, “I loaned the company $10,000 this year, but counting all the prior years, I lent the company $110,000. “
“We purchased another business about nine years ago,” Brian said. “It didn’t work out, and Alice loaned money to the company to keep Thompson Engineering going. It meant we didn’t need to go to banks for money, something I’ve always tried to avoid.”
“But your income tax forms don’t show any interest earned on the loans,” I said.
“Paying Alice interest didn’t make sense to us,” Brian said. “She’d just have to pay tax on the income the company pays to her. And the company’s tax rate is lower than Alice’s, so the family would lose by paying her interest.”
“Alice isn’t a shareholder in the company,” I said.
“That’s right,” Brian said. “I own all the shares. Alice does come in from time to time. She does the books and some other administrative work.”
“To my mind, you have a problem,” I said. “If the debt goes bad, Alice won’t be able to claim a loss for tax purposes because she didn’t enter into the loan to earn income.”
“Yes I did,” Alice said. “I work in the business myself, and I made the loan so the family can prosper.”
“I understand your thinking,” I said. “But the law is very clear on this point. If you don’t earn income from a loan and you’re not a shareholder of the business, you won’t get a tax deduction if the loan goes bad.”
“I don’t think we have to worry about that,” Brian said. “Alice’s loan isn’t going bad.”
“I hope you’re right,” I said. “But that’s no reason not to protect her. By not setting up the loan to Thompson Engineering as carefully as you would make any other investment, you’re short-changing yourself and the family as well. My advice is to charge interest — even if you reduce your salary by the interest you pay — and secure your loans. That will give your debt a preference over unsecured loans like supplier payables. And consider this: if the company isn’t earning enough to pay interest, shouldn’t that sound an alarm in your head?”
“Do you think the company is in financial trouble?” Alice asked.
“I’m not saying that, but consider the numbers. Alice earned $40,000 last year from the business. She paid about $8,000 in taxes, so she received $32,000 after tax. Then she loaned back $10,000. That gave her after-tax cash flow from the business of $22,000. If she had taken a salary of just $30,000 and left the $10,000 in the company, she would have paid taxes of only $3,000. That would have given her cash flow from the business of $27,000. She would have been $5,000 ahead.”
“So you’re saying, we could have done this smarter?” asked Brian.
“Yes. But I’m also concerned that the company now depends on Alice’s cash injection each year. Maybe there is some way you could figure out to earn more money from the business. Your company grosses nearly $300,000 a year. If you could find a way to keep just 1% more of your revenues, you’d be up $30,000. That would solve many of your problems. I think if you worked out a formal business model for your company, you could boost your net profits by that amount.”
“What’s a business model?”
“It describes the Who, What, How, When and Why of your business. Who you serve. What you do. How you do it. How much you charge. When you do it. And why people need you. I’m afraid these persistent loans from Alice are a danger sign. That’s why a business model is something you should strongly consider doing right now.”
Hank Bulmash, MBA, CA is a principal of Bulmash Cullemore, chartered accountants of Toronto. To receive more information and an e-report, e-mail Hank at firstname.lastname@example.org with “Business Model” in the subject line.