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Tax Return Analysis

Double-counting Pass Through Cash Flow

Joey asks:

I am concerned about double-counting income on pass through entities. Here is my example: XYZ company started 1/1/17. The company made $100,000.00 in profit. The personal tax return of XYZ owner (100% owner) Schedule E shows the pass through income of $100,000.00.

The company also had a distribution of $100,000.00 at year end. I have seen some people count the pass through income and distribution for the personal analysis. To me it appears that’s double counting in the personal analysis, because the first year company only made $100,000.00 yet you are showing the $100,000.00 pass through income as well as the $100,000.00 distribution. What do you think?

Linda says:

You are 100% correct, Joey. The $100,000 in Schedule E is what they are taxed on.

If the owner also had a distribution of $100,000, that is what they took home. It is totally a coincidence that they are the same amount, and it is rare that they are. Let me give you a scenario and let’s see if we agree on the answer:

What is the actual cash flow?

  1. Company shows $100,000 taxable income and that is reported on the 1040 Schedule E of the 100% shareholder.
  2. The K-1 from the 1120S shows a distribution of $70,000.
  3. The 1120S shows $45,000 depreciation, $10,000 amortization, $80,000 wages to the owner and interest expense of $1,000. The Schedule L shows end of the year principal due in the next 12 months of $12,000.

What is the actual cash flow the owner received from the company?

****

I am pausing while you figure out your answer.

***

What can the company afford?

I am again pausing while you figure out your answer.

***

Let’s compare answers

Here is my take on it, Joey.

  1. The amount of taxable income of $100,000 is irrelevant.
  2. The shareholder took home $70,000 in distributions and $80,000 in wages (indicate in item 3 above) for a total take-home of $150,000.
  3. The company can afford $223,000, which I calculated based on $100,000 taxable income, add back shareholder wage $80,000, non cash depreciation $45,000, non cash amortization $10,000 and subtract principal due in the next 12 months of $12,000. The amount of cash flow available to pay the owner, after debt payments and before the payments they DID make to the owner is $223,000. (CHECK MY WORK…I just made this up so maybe I made a mistake).

So, do you use $100,000 or $150,000 or $223,000. I believe a case could be made for either of the last two numbers. Certainly you can use $150,000 instead of the $100,000, especially because it appears that the company paid $150,000 and can afford that and more. If you are the business lender, you may know why the owner took less than the company appears to be able to afford. Maybe they are leaving funds in to finance growth or pay down more than the required debt. Maybe they are building liquidity.

Business vs Personal Analysis

Your question focused on a personal analysis. While a business lender might delve into the business more closely, you might be just fine with the $150,000 at this point. But if $150,000 is not enough for your purposes and $223,000 is, you may have a case for including more in the personal analysis.

Joey says thanks!

I can’t help including Joey’s thanks to my response.

Hello, Linda. First and foremost, I’d like to thank you for reaching out to me with your busy schedule. It is greatly appreciated! Secondly, I’d like to say I thoroughly enjoy your blog and articles I’ve seen across the world wide web. They have been insightful and very helpful.

I agree with there being a case for both consideration in the personal cash flow in your example. I heard this a couple months ago, but underwriting is more of an art than just form filling. Your scenario above is a perfect example.

Again, I thank you for your time, and look forward to reading more of your articles, blogs, and insight.

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About the Author
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.