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Passive vs NonPassive Losses: What is a lender to do?

Desi’s question:

Can passive &/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 non passive that determines if it can be added back to cashflow. It is whether it represents significant, continuing source of (or depletion of) cashflow.

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 mean:

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:

  • Order manuals for self-study and continuing resource. Imagine a dictionary and an encyclopedia of tax return analysis rolled into one. comprehensive self-study manuals .
  • Attend our Virtual Training on Tax Return Analysis for Bankers Click here for more info and to register.
  • Request In-Person Training
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      • In-house…we’ll customize the training to your needs, your lenders, your guidelines, your software
    • comprehensive self-study manuals
    • Contact us to learn more or request the training
About the Author
Linda Keith CPA is an expert in credit risk readiness and credit analysis. She trains banks and credit unions throughout the United States, both in-house and in open-enrollment sessions, on Tax Return and Financial Statement Analysis. She is in the trenches with lenders, analysts and underwriters helping them say "yes" to good loans. Creator of the Tax Return Analysis Virtual Classroom at www.LendersOnlineTraining.com, she speaks at banking associations on risk management, lending and director finance topics.