What’s your opinion on the concept of underwriting with K-1s versus full returns on affiliated entities?
At present, we collect a minimum of two years tax returns from all principals, the borrower, and each of the Schedule E pass-through entities. The number of affiliate companies sometimes numbers more than 40, and this is very time consuming.
We’re considering focusing on the project performance, supported by a review of the principal’s liquidity and leverage taken from their PFS and K1 information. Affiliate income would be captured as net income available for cash flow reported on their personal tax returns on Schedule E, Page 2. There would be no need to collect affiliate tax returns and spread them in the global worksheet.
We think the net income approach would be more conservative. What do you think?
My first thought is that sometimes the net income approach will be more conservative, and sometimes less. Global analysis is a place where opinions and guidelines vary quite a bit. My opinion is based on seeing guidelines of many financial institutions, along with a deep understanding of what the various numbers on the tax returns actually mean. Any number of our readers might disagree with my approach. Many will agree. By the way, this is not one of those quick answers you can skim. If you want to understand it, get ready to think and ponder.
Sources of repayment
The impact of an ‘affiliate’ company is way down on the list of source of repayment. Here are my top three:
- Primary source of repayment is the business so a full analysis of the business borrower is appropriate.
- Secondary source of repayment is the collateral.
- Third source of repayment is the owners, considering cash-flow and liquidity. A global analysis with the owners other sources of cash-flow can help you determine if the owners are a plus or a minus in the overall loan decision.
Entities owned by owner/guarantors but unrelated to the borrowing entity
Unless you expect to have another business guarantee the loan, which is often challenging to accomplish, then the primary reason to analyze entities not obligated on your loan but owned (or co-owned) by your owner/guarantor is to consider if the owner/guarantor’s income from that entity, which you plan to include in your global analysis, is reliable and recurring. A secondary reason is to assure yourself that the owner guaranteeing your loan is not knee-deep, or worse, in alligators.
The cash flow to pay business owners comes from six sources:
- Margin from normal operations
- Windfall income (insurance settlement, etc)
- Selling capital assets
- The company borrowed money
- Other owners put money in
- They ran down liquidity (reduced their cash)
Obtaining the full returns of entities that are related but are not going to be obligated on the loan, in my opinion, is primarily to consider the impact on the owner/guarantor cash-flow. Are the K-1 distributions and guaranteed payments supported from normal operations? Is the ‘other’ business in such trouble financially that the owner/guarantors might be tempted to funnel off money you are lending to your borrower business to save themselves in another business or project?
What to include in global analysis:
- Full analysis of borrowing business
- Full analysis of owner/guarantors
- This might be all of them or any with over X% ownership, per your guidelines.
- This might include actual cash-flow from other owned entities in the form of wages (if corporation), distributions/withdrawals and guaranteed payments, possibly offset by capital contributed.
- As an alternative, some lenders will include share of cash-flow available rather than actual cash-flow, particularly if the lender feels that share of available is a better indicator of what the owner can take in the future. Or they may compare them and take the lesser of what the owner/guarantor took (per the K-1) or what the company can afford to pay.
Does the ‘other’ business have to come to the table if your business borrower needs it?
Not unless you secured a guarantee from the ‘other’ business. So a cash-flow available calculation in global cash-flow is not included because the other business ‘has to’ make good on the loan, but because, in your judgement, the share of cash-flow available to the owner/guarantor is a more reliable guess than what the owner/guarantor has actually been taking.
If it is a pass-through entity (S Corporations, Partnerships or multi-owner LLCs), does passive vs non-passive make a difference?
I believe it does. If, on 1040 Schedule E Page Two, an entity is listed on the passive side, the owner is not active in the business. The owner is not making management decisions.
In my experience, it is more likely that the owner owns a small % of the business or investment. And it is likely the owner has not personally guaranteed the loans of the business/investment. It is possible, however, that a minority owner who is not active in the business has agreed to a call provision. This means they may have to put more of an investment in if called for.
If the entry on 1040 Schedule E Page two is listed on the non-passive side, the owner is active in the business. In my experience, the owner is more likely to be a higher percentage owner and is more likely to have guaranteed the debt. It is more likely this is a significant source of the owner’s personal income, in the form of wages, distributions or guaranteed payments.
Do I have to get the same detail on these non-obligated entities that I do for the one I am lending to?
Probably not. For example, consider leaving interest in and subtracting principal due in the next 12 months from the balance sheets when analyzing a 1065, 1120 or 1120S. This is a shortcut that does not work as well as all debt info, but may be good enough for you to assure yourself that the cash-flow from operations supports the owner compensation.
You also will not have as much information about expansion plans, and may not be able to spot nonrecurring items. You just will not know as much about this entity as you do your borrowing entity. But if the result of this simplified business cash-flow is positive, after all owner distributions and debt principal payments are covered, you are in a good position to rely on the owner actual distributions in your global analysis.
What numbers from the K-1 should you consider for evidence of actual cash-flow?
I do not use Line 1 of the K-1 (1065 or 1120S) as cash-flow to the owner. It is more like AGI, an allocation of taxable income from the source return.
On the 1120S K-1, use Line 16 with a code of D which stands for distributions. You may consider Line 16 with a code of E, which stands for repayment of loans from the shareholder. With a 100% owner, I definitely would. It is likely that once the loan is paid off, they’ll continue to make distributions. If it is a <100% owner, maybe not. On the 1065 K-1, use distributions (Line 19, Code of A) plus guaranteed payments (Line 4), less capital contributed (Section L).
There are a lot of other numbers on the K-1s, but they represent either allocations of taxable income or losses, or are other numbers the 1040 preparer needs to calculate taxable income. For cash-flow purposes, ignore them.
How to pare it down?
If you are looking for a reasonable way to sift out which non-obligated entities you should look closely at and which you may be able to afford to look at less closely, consider:
- Non-passive is more likely to represent higher % ownership, an owner guaranteeing a loan, a significant source of personal income
- Some lenders consider % ownership. i.e.
X% require full return plus the K-1. Use K-1 actual cash-flow but determine through full analysis that the operations support the owner wages, distributions and guaranteed payments.
- Some lenders, rather than considering % ownership, consider % of overall income. Thus if I were a 20% owner of my company, but it represents $200,000 a year of cash-flow, that lender might still take a look at the entire company to be sure it can still support the income I am taking.
- Some lenders ignore passive income/loss if the owner owns <10%, for example, and the income is less than 10% of overall owner cash-flow.
So what is the answer?
That is your call, Barbara. Hopefully, with our discussion and some of the additional info provided above, you can make a good decision and share the basis for that decision with the underwriters you work with.
Need to understand K-1s, passive/non-passive and pass-through entities better?
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