Desi’s question:
Can passive and/or non-passive losses on the 1040 tax return be added back to borrower/guarantor cash flow for global analysis? I am having trouble finding a definitive answer to this question.
Linda says:
There is a reason you are not finding an answer to your question. It is not whether something is passive or nonpassive that determines if it can be added back to cash flow. It is whether it represents a significant, continuing source of (or depletion of) cash flow.
If you are thinking about the 1040 Schedule E Page Two, where 1065 and 1120S income and losses are reported, here is what the choice of passive vs non-passive columns means:
Passive
The income or loss is from an activity in which the owner is not actively engaged but rather is an investor.
Frequently the owner % is extremely low and the K-1 is sufficient to determine continued availability of cashflow. If there is capital contributed because this is the first year in the investment, that capital contribution is likely not going to be required each year.
To be sure you would need to ask, and perhaps gain documentation, as to whether there is a call provision requiring additional capital contributions if needed. With a low % owner in the passive category, it is rare to require the full 1065 or 1120S Tax Return to determine cashflow from the passive activity.
Non-passive
The income or loss is from an activity in which the owner is actively engaged, not just an investor.
Does that mean the loss is recurring? Don’t know. For that, you need to either obtain the full source return (1065 or 1120S) for two or three years and calculate cashflow from operations or review the K-1.
If analyzing the full return, look to see if on the face of it some of the underlying revenue or expense items are non-recurring.
- Insurance or law suit settlement received or paid
- Disaster repairs
- Merger costs
- Bad debts
Does that mean the loss has a cashflow impact on the borrower/guarantor? Don’t know. For that you need to consider both the overall cashflow available (as per above) or the actual cashflow based on a review of the K-1.
Particularly if the business owner only owns 10%, you might be comfortable with determining the actual cashflow as indicated by the K-1. This choice makes a simplifying assumption that what the owner has taken in actual cashflow in the last three years is indicative of what s/he will be able to take going forward.
What to use in your global cashflow calculations
As a practical matter, I do not use any number that is on 1040 Schedule E Page two, whether it is in the passive or non-passive side. I decide if I need just the K-1s or the full source returns and look to them for cashflow.
The borrower/guarantor’s % ownership along with whether the borrower/guarantor is an investor (passive income/loss) or an active business owner/decision maker (non-passive income/loss) can be helpful in deciding which you want…K-1 only or the full return.
What do you use?
What are the guidelines in play at your financial institution for whether and when you can use
- Numbers from 1040 Schedule E Page 2
- Numbers from K-1s
- Numbers from 1065 or 1120S
Learn more
This post is really about two areas that can cause confusion for lenders;
- Passive versus non-passive
- Cashflow analysis of pass-Thru entities (S corporations, LLCs and Partnerships)
If you need more help on either of these:
Here is the link to our demo so you can see for yourself what learning with Lender’s Online Training is like.
We have also “written the books” on Tax Return Analysis. Check out our Lender Training Manuals.
