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Should Global Analysis include all related entities?

Erica’s question:

I am lending to an LLC and requiring all owners to sign on the loan. An owner’s spouse owns a business that will not be signing on the loan and is not integral to the company I am lending to. I am using her income from that business as part of the global income to qualify. Do I need to review that entity tax return?

Linda says:

Erica, this is a question with several possible answers depending on the approach of your financial institution. Let me give you three possible answers, all of which I have run into in my client’s guidelines and/or practice, and you can decide which fits for you.

You say you are using her income from that business as part of the global income to qualify…but how important is that income to the overall global analysis? And how hard and fast are your guidelines?

When I refer to the ‘unrelated’ entity below I am focused on its relationship to the operations of the entity you are lending to.  While the entity in question is related through a common ownership, it is unrelated to your prospective borrowing operation. So what type of cashflow analysis of the ‘unrelated’ tax return might be required?

First choice:

Consider how important the unrelated entity is either to repayment of the loan you are making or risk to the guarantors.

  • Is the business loan you are considering extremely solid?
  • Is the guarantor analysis primarily to be sure there is not a black hole that will suck income from the borrowing business?
  • Is it your judgement that the unrelated entity is not a significant source of risk to the guarantors?

Then you may not need to look at unrelated entity tax returns also owned by the guarantors if in your judgement the income from that entity is not critical to your approval of the loan and the unrelated entity does not pose a significant risk. How much wiggle room do your guidelines allow for lender judgement?

Second choice:

Some guidelines are pretty hard and fast. Are you including any of the following income from the entity in the global analysis?

  • Wages from a c-corp or s-corp,
  • Distributions from an s-corp,
  • Withdrawals/guaranteed payments form a partnership/LLC)

Does the guarantor own over X% (often 20% or 25%)?

Your guidelines might require you get the full return. Perhaps you’ll have to use the actual cashflow taken by the owner but be sure the entity can support that amount on a continuing basis.

And if the guarantor’s share of the entity recurring cashflow is less than what they are taking, you may be required to use the lesser amount. This is a fairly conservative approach…the lesser of actual cashflow taken or apparent cashflow available. That is another choice, and then…

Third choice:

Same as the second answer but if over your % threshold, use guarantor’s share of entity cashflow whether it is higher or lower. This is less conservative and recognizes that if there is enough ownership, the owner/guarantor has access to additional funds.

Some of my clients will require the tax return if ownership is over 25%, but only allow you to use apparent excess cashflow if over 85%.

Others will only allow you to use apparent excess cashflow if upon your review of the source tax return you can explain why the owner/guarantor took less that year. Perhaps the company was expanding, or paying down debt, or had an unusual situation like disaster repairs to deal with.

When not to follow the guidelines

Well, actually, it is part of the guidelines of many financial institutions that as a lending professional, you need to use your judgement. If, for example, you are not required to get the underlying tax return if the guarantor owns <25%, but you just did the loan for another owner with >25% and know the entity is in deep trouble, it is likely your financial institution would require you use your judgement and request the full return.

For many of you, guidelines are guides…not hard and fast rules.

A word about consistency

Be aware that if you depart from guidelines, even if for a great reason, inconsistencies creep into the loan files which can be a challenge when the regulators pick that file, or when a lending professional new to your organization is trying to figure out the guidelines from past practices. Take the time to explain why you are doing what you are doing. Someone may not agree with your judgement, but they should be able to see the thinking behind your choice.

Is it going to be a performing loan?

That is what we are trying to determine. Based on your guidelines and what else you know about the borrowing entity, the owner/guarantors, the outside conditions, and anything else that will impact repayment, do you think you should request and review the non-borrowing entity tax returns? That answer may change from one loan to the next.

Resource to help you…

If you do not yet have it, request the Quick Reference Guide below and take a look at the worksheets for S-Corporations, Partnerships and C-Corporations. You’ll see how I determine the cashflow available from the entity to the owners.

Then look at the K-1 summary to see how actual cashflow is determined from the pass-thru entities filing 1065 or 1120S. Then you are in better shape to decide between them.

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.