Franny’s question:
My borrowers reported $7,000 non-passive income in 2011, and $42,000 passive income in 2012 from the same business. Do I count both as income and average them over the 24 months?
Linda says:
I would not count anything listed on the back of 1040 Schedule E as is. And if the return is done correctly, the shift from non-passive to passive tells you the nature of their involvement has changed in a way that might impact how I treat the income/cashflow.
1040 Schedule E Income/Loss
Taxable income or loss listed on the 1040, Schedule E, Page two is just that…taxable income. It is not cashflow actually paid to the partner/shareholder. It is not what the company can afford to pay. So I do not use it.
Based typically on % ownership, I’ll ask for the full return (1120S or 1065) if
- Borrower/Guarantor’s income is primarily from this entity and is crucial to the deal.
- Borrower/Guarantor is a high-ish % owner
- Your guidelines determine this. 25%+ is common. SBA uses 20%+. Some lenders don’t bother unless it is 51%+. And I am working with an indirect lender that always uses the k-1s instead of the full return regardless of % ownership.
- Borrower/Guarantor is a general partner
- General partners have unlimited liability regardless of how low their % ownership
Switching from non-passive to passive…what does it mean?
If the returns were done correctly, the switch from non-passive in 2011 to passive in 2012 would imply they were actively engaged in the business/investment decision-making in 2011 and by 2012 were not actively engaged. I still would need k-1s to know what the cashflow really was.
When to use the Schedule E, Page Two Income/(Loss)?
If I were Queen for the Day, the answer would be never…well, almost never. I have one client who, if it is passive (meaning they are an investor), and it is a small loss, does not require the lender get any additional information and uses the loss. If it is a passive small-ish gain, they do not require additional information but leave the gain out.
If you do get the full return or the k-1’s, it is likely the cashflow available and the actual cashflow to the Borrower/Guarantor is very different than the $7,000 and the $42,000 taxable income reported on the 1040.
