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Tony Asks:

I used distributions from owners’ equity as part of the cash available for personal debt service of the owners of a law firm. The firm had a large settlement 2 years ago which continues to be the source for wages and distributions.

This firm consistently takes on multi-year cases and uses the big wins to fund the company for several years as it works on another major case. When I proposed using the wages and distributions even though in the current year, operating income did not cover it, the response I received was black and white. “We don’t use it.” Under what circumstances might you make the case to treat distributions as available when the firm experienced a loss?

Linda Says:

Are you saying you wanted to use distributions from the Law Firm as cash available to the owner for debt service of the owner? The answer, “It depends” comes to mind.

Is it recurring?

Many S-Corp shareholders get paid in a combination of wages and distributions regularly. So if the distributions to the owner are regular and recurring, most analysts will include them.

That said, just because distributions are recurring does not mean they are supported by operations. That is the concern.

Is it supported?

When a company has a one-year operating cycle, it is easier to tell if the distributions are supported by operations. And you are absolutely right, it really does not matter if it is wages or distributions. The choice between those two options is not what is normal compensation but is, instead, based on saving payroll taxes.

When a company has a multi-year operating cycle, or regularly engages in activities that can take longer than one year to play out, determining cash available to the owners requires a multi-year look and discussion with the owners as to their current projects and plans.

Your example of a law firm that works on big cases is a good one. So is a construction company working on large municipal projects.

From equity or excess liquidity?

I would characterize this as distributions from excess liquidity available because of the windfall nature of the prior year’s success. It makes more sense to think of it that way.

In our extended email correspondence, you indicated they pay themselves distributions typically from that year’s profits. But in the case in question, the distributions you used were from owner equity since the firm didn’t make a significant profit in 2022. Again, I believe if you characterize it as liquidity available because of the windfall of the prior year, it might resonate better. 

More history and evidence of current activity

If you normally use two year’s history you may need to go three or even more. And you will need to document the conversation with the borrower regarding their current activities. Is there documentation you can think of that shows their activity? 

For example, if you could make the case that the two partners who own 100% of the firm had enough money from profitable years to pay themselves the same total wage for 5 years even in years when the firm just made enough to offset current years debt, that could be powerful. 

Isn’t equity the build-up from profitable years?

Yes,  but it does not necessarily stick around in equity if they took the excess profits out as distributions at the time. And some analysts would say it does not matter if the owner has sufficient liquidity. The first choice is always operating margin to cover payments to owners as well as debt coverage. The second choice is adequate liquidity somewhere. The business is great but with a high percentage owner with plenty of liquidity, it might not matter where it is.

So your next question is how is their liquidity now? And is the fee expected from pending litigation a done deal or is it contingent on winning the lawsuit?

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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.