Catherine asks:
What is the depreciation figure on the 1065 Schedule M-1, Line 4a for? I don’t see that we ever look at this figure to “add” back. Has this already been calculated into the depreciation figure on Page 1, Line 16?
Linda says:
Schedule M-1 is on the returns (1120, 1120S, 1065) because the IRS wants the taxpayer to reconcile the net income that goes with the attached balance sheet (Schedule L) with the income they are paying taxes on. It is just info the IRS wants. That said…
Your method might make a difference
In your email, Catherine, you added that you use the AGI cash flow method, the form provided from MGIC’s website, and you work with secondary market rules. AGI or Schedule Analysis Method does not modify my answer, but if you were a lender using Moody’s, Baker Hill or an approach that starts with net income per books, it would make a difference. And AgLenders often take another approach altogether.
First, I’ll cover the basic info. Then the variation for the ‘net income per books’ and the ‘aglending’ approaches. Feel free to quit reading when you get your answer.
It is all about timing
One of the differences between net income per books (that works with the Schedule L Balance Sheet) and taxable income is depreciation.
The M-1 entries for depreciation on either the left or the right (1065 Lines 4a and 7a) are related to timing. 4a is depreciation on the books not on the return. Since you start with the taxable income on the return, you do not need to add back depreciation that is not in the taxable income number. Line 7a is depreciation on the return, not on the books. It is already included in the page one depreciation you add back.
So the short answer to your specific question is that for secondary market lenders using the AGI method, you only add back the depreciation on page one of the 1065, 1120 and 1120S returns. If you want to understand more thoroughly how depreciation is handled, read on.
Here is how it works:
Scenario One: Accelerated Depreciation vs Straight-Line Depreciation
Let’s assume the books are using accelerated depreciation and the tax return straight line. This is often because of some requirement or limitation in the return.
If the company purchased the asset for $200,000, they would write off against taxable income $40,000 for five years. But on the books they might use this schedule: $60,000; $50,000; $40,000; $30,000 and $20,000.
Only in year three would book and tax return depreciation be the same, requiring no adjustment on the Schedule M-1. Year one you would have $20,000 on M-1, Line 4a. Year two $10,000 on 4a. Year four $10,000 on M-1, Line 7a and Year five $20,000 on M-1, Line 7a. They both get to $200,000 eventually, just at a different pace.
Scenario Two: Write-off in first year (Section 179)
I buy a $200,000 item and use the tax return depreciation option to write it all of first year. On the books, I write it off over 5 years so straight line depreciation is $40,000 a year.
If that is the only equipment I have, year one depreciation is $200,000 and is reported on the 1120 Page One depreciation line. If the entity is a pass-thru filing a 1065 or 1120S, the $200,000 is still on the return but is on Schedule K (Owner’s Distributive Share Items). In either case , M-1 Line 4a is zero and line 7a is $160,000 because I deducted $200,000 depreciation on the return but only $40,000 on the books.
I occasionally see an entry on M-1 Line 4a and on M-1 Line 7a on the same return instead of a net depreciation adjustment on one side or the other, as is my preference. As long as the tax preparer ends up with the same net result, I do not think it should matter to a lender/analyst where the preparer put it.
Year two through five page one and Schedule K depreciation is zero if I did not buy something new. M-1 Line 4a is $40,000 since there is book depreciation for one year and none on the return.
Eventually I will write everything off both on the return and in the books.
Another approach for business lenders:
Some business lenders actually start with M-1 Line 1 Net Income per Books instead of with Taxable Income. For them, they need to add back depreciation on page one and Schedule K (Section 179), and also add M-1 Line 4a depreciation on the books and not on the tax return and subtract M-1 Line 7a depreciation on the tax return and not on the books. If you think that is not intuitive, I think you are right!
Please note: The M-1 Line numbers can change from time to time. The M-1 depreciation to add is on the left side of the M-1 (depreciation on the books and not on the return). The M-1 depreciation to subtract is on the right side (depreciation on the return and not in the books).
AgLenders often ‘ignore’ tax return depreciation
In AgLending, it is critically important to consider if the operator is replacing equipment at a pace that will sustain the operation. In my experience, AgLenders generally do one of three things with depreciation:
Use the page one tax return depreciation with or without the Schedule K Section 179 but enter it on a line in their worksheet that will eliminate it for debt repayment capacity calculations.
Replace the tax return depreciation with a calculated ‘use cost’ or ‘normalized depreciation’ based on the type of operation and the value of the equipment or buildings in play. This improves the analysis of the ‘earnings’ section of the worksheet. The software still removes this figure for debt repayment capacity.
Use the use cost or normalized depreciation in an additional ‘Capital Asset Replacement’ analysis to consider if the operator is replacing capital assets as needed.
Unlock the foundations of financial analysis with our “Depreciation” module
This is an essential starting point in our Tax Return Analysis course at Lenders Online Training. Dive into the fundamentals of depreciation to build a solid understanding, setting the stage for more advanced courses in Tax Return Analysis and Financial Statement Analysis.
- Purchase our Lender Training Manuals
- Enroll in Lender’s Online Training. We have six modules on the pass-through entities, and two specifically on K-1s.
