Beware of deducting personal expenses in a business, the cost could be very high. In July a 23, 2020 Tax Court of Canada case, at issue were a number of expenses claimed by the taxpayers (a corporation and its sole individual shareholder) in respect of the business of selling financial products and providing financial planning advice. CRA denied various expenses spanning 2007 and 2008 and assessed many of them as shareholder benefits. That is, the amounts were taxable to the individual shareholder and not deductible to the corporation.
CRA also assessed beyond the normal reassessment period on the basis that the taxpayers made a misrepresentation attributable to neglect, carelessness, willful default or fraud. They also assessed gross negligence penalties which is computed as the greater of 50% of the understated tax or overstated credits related to the false statement or omission, and $100.
The following expenses were reviewed:
- bonuses paid to family members who were not employees of the taxpayer;
- payments to family members under an Employee Profit Sharing Plan (EPSP) where there was no evidence that the payments referred to profits;
- salaries paid to family members (including the shareholder’s daughter who received a salary of $5,000 in 2007 and $400 in 2008);
- salaries paid to the taxpayer’s children’s care providers;
- salaries to the taxpayer’s former spouse, which the taxpayer argued was the same as personally paying spousal support;
- travel costs for the taxpayer and his family to go on a cruise on which the taxpayer made business-related presentations (CRA conceded the taxpayer’s travel costs);
- significant interest expense with very little support; and
- many other costs such as clothing, toys, jewelry, personal items, lawncare, maid service, and pet care for the shareholder and family members.
While the taxpayer originally claimed the travel expenses for the taxpayer’s family to travel to Hawaii for a shareholders’ meeting, the taxpayer conceded these amounts.
The taxpayer argued that any benefits taxable to him personally were conferred by virtue of his employment, not his shareholdings, and, therefore, should be deductible to the corporation.
In dismissing the taxpayer’s argument, the Court found that the vast majority of expenses reviewed were personal in nature and denied the deduction. The Court also found the vast majority of denied expenses to be a shareholder benefit. These expenses were not, by and large, expenses a reasonable employer would otherwise pay for the benefit of an arm’s length employee. The taxpayer, through his unfettered control, chose not to pay salaries or bonuses but rather to deduct the disallowed expenses from the corporate receipts and never report or ascribe any amount of benefit or employment income to himself.
The Court upheld CRA’s assessment beyond the normal limitation period as well as gross negligence penalties, noting:
- the sole shareholder’s education and training regarding complex tax integration, small business deduction strategies, and corporate/personal lifestyle structuring;
- the individual unilaterally directed which expenses the corporation should deduct, even though some were clearly personal; and
- the degree and scope of the upheld assessments were very large – in excess of $700,000 for the corporation and in excess of $1,100,000 for the individual, both spanning a two-year period.
The Court stated that the gross negligence penalties exist for these such situations: sophisticated taxpayers must appreciate that using corporate structures to mask inappropriate deductions and shield personal income from tax should not be done.
The result of these inappropriate deductions was effectively triple taxation – corporate tax on disallowed deductions, personal tax on shareholder benefits, and a 50% gross negligence penalty on both the corporate and personal taxes. It would have been much cheaper had the taxpayer taken additional salaries or dividends, and paid the additional taxes up front, rather than running personal expenses through the corporation.
In the case where personal expenses are paid by the corporation, the accounts should generally be corrected by adjusting the shareholder loan account or having the individual pay the corporation back. This was not done in this case.
ACTION ITEM: As best as possible, keep business and personal expenses separate. Deducting personal expenses in a business (corporation) can lead to a very costly bill, well in excess of the tax that would have been payable if the amounts had been reported correctly.