June 4, 2013

When non-passive income in one year is passive the next

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.

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Linda Keith, CPA

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.

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