I’m working with an S Corporation that reports a significant value on their Schedule K (line 12d) labeled as Qualified Production Activity and Employer’s W2 Wages. We have counted it as cash in the past but it seems to me that it is only a taxable deduction and should not be counted in the cash flow. Is this a true cash item?
The short answer is: Do not use it. The longer answer is more interesting, as usual.
If you are thinking to yourself, of course we use S Corporation wages to shareholders, my short answer may seem counter intuitive. Read on.
The figure on Schedule K (line 12d) labeled as Qualified Production Activity and Employer’s W-2 Wages is information for the preparers of the shareholder 1040. It is not additional expenses or cash flow out of the corporation, nor is it cash flow to the shareholder.
What is it, then?
A shareholder, subject to some limitations, enjoys a deduction on Line 35 (just before AGI) based on a % of qualified production activity. It is not an amount they spent, just a break they get. The only way cash flow is impacted is that the deduction reduces their federal income tax.
Why is the S Corporation K-1 so complicated?
Both the 1065 and the 1120S K-1 includes a lot of information that is solely of interest to the tax preparer so we can get the next return right, whether the partner/shareholder is a 1040 filing individual or another entity, such as an LLC, Partnership or S Corporation.
When a lender is analyzing the tax returns for global, entity or individual cash flow you can, and should, ignore most of what is there.
What should we use from a K-1?
- Plus Guaranteed Payments
- Less Capital Contributions
- Distributions (Line 16, Code D)
The S Corp wages you use are on their 1040, Line 7, along with all other wages. The 1120S K-1 does not show capital contributions so you do not have that information. And some credit analyst/underwriters will use Repayment of Loans from Shareholders (Line 16, Code E). It is cash flow. It may or may not be recurring after the loan is paid off. Might be worth getting more info.
Asked and answered
Here is another related questions and my answer. Just a slightly different take that might be helpful.
More help on K-1s?
In Lender’s Online Training we have three online modules on each of the pass-through entities, 1065 and 1120S. The third for each is specifically on the K-1s, although all three are necessary to get the full picture.