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Jackie asks:

My bank has a lot of financial services clients who participate in investment vehicles (private equity/venture capital funds) that issue a 1065 K-1. In our goal to give them credit for the cash flow resulting from this activity, we will give them credit for the cash flow (distributions plus guaranteed payments less capital contributed). However, we frequently field questions about how this relates to the main 1040.

Where do the taxable income amounts from the k-1 show up in the 1040? And where do guaranteed payments and distributions show up? (I think distributions do not, but where are guaranteed payments?) And do we need to decide which to use? I think we are in danger of double-counting.

Linda says:

You are correct that you need to decide which to use. Counting distributions and guaranteed payments (actual cash flow) as well as income (ordinary, dividends, rental, capital gains, interest etc.) would be double-counting. We either give them credit for what they actually take or what the entity can afford to pay them, but not both.

Where are the guaranteed payments on the 1040?

Guaranteed payments flow through to Schedule E, Part II but are combined with ordinary income and adjusted for a few other items. So the amount on the 1040 Schedule E, Part II may be only their share of taxable income. But it also may include guaranteed payments, which are actual cash flow. Distributions do not flow through to the 1040, however.

Where are the pass-thru capital gains?

The Schedule D has a line in the short-term gains/losses (Part I) for capital gains from Schedule K-1 and another line in the long-term gains/losses (Part II). In the module on Schedule D analysis in Lenders Online Training, I explain why we should first determine if anything on the D is actual cashflow. Both K-1 pass-through and carryovers can roll into that Schedule. Neither represent actual cash distributions.

If you want to know the actual cash flow to the investor, you need the K-1.

How to Choose

Generally, when calculating owner/guarantor cash flow, we choose between the actual cash flow (by analyzing the K-1) or the cash flow available, by analyzing the full entity return and giving the owner/guarantor credit for their share. As to capital gains reported on the entity return, you need to decide what is recurring before you decide the owner/guarantor’s share of recurring gains/losses.

The big question is which you believe is the best indicator of cash flow going forward. If you use K-1 distributions and the owner/guarantor has been taking out more than the company can afford, you are relying on that entity to continue a potentially unsustainable source. If it is an operating company, this could be selling operating assets, borrowing money, owner contributions or loans, or a windfall of some sort. Without looking at the source entity return, you have no idea if the distributions and guaranteed payments are sustainable.

If you use available cash flow instead of what they actually take, then you may miss that they are raiding the company of unsustainable cash flow. Or taking much less out than the company can afford from operations or investment activity, which may signal a choice to leave the funds in the company for growth, for accelerated pay down of debt or further investments.

More on K-1s and Capital Gains

www.LendersOnlineTraining.com has three modules on 1065 analysis and three more on 1120S analysis. It is all about avoiding double-counting, from the proper analysis of the company on its own, to the global cash flow of the borrowing entity, related entities not obligated on the loan, and the owner/guarantors. Yes, it does get complicated!

There is also a full module on capital gains and losses. What is ‘real’ on the D and what is ‘fake’!

Lenders Online Training on tax return and financial statement analysis

Click through here to see if this is a resource you are ready to handle!

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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.