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  • Interest from a K-1 on Schedule B: Count it or not?

Here is how you end up with Interest from a Schedule K-1 on 1040 Schedule B:

  • Schedule B includes all taxable income.
  • Interest income received by an S Corporation or a 1065-filing entity like an LLC or partnership is passed through and taxed to the owner of the company
  • Thus interest not received by an individual will be listed on Schedule B

This is another example, once again, that taxable income is not necessarily cashflow.

What do you count?

My favorite answer…and if you are a regular reader of my blogs or have attended my training for lenders and underwriters on Tax Return Analysis…you know what is coming! It depends.

My approach

I do not include Schedule K-1 Interest in personal cashflow. The 1040 filer did not receive that cashflow. It does not mean they did not receive ANY cashflow from the company. But if they did, we’ll find what they actually received on their K-1.

The K-1 is a schedule of the 1120S or 1065, not the 1040. So you won’t have it unless you ask for it.

It still depends

With a lower % owner, of if you only want to consider actual cashflow from the company to the owner/guarantor, obtain the K-1 and cashflow that. Don’t know what to use? Time to come to class, take the Business Tax Return Analysis series of nine eCourses at www.LendersOnlineTraining.com, or order the manual.

Okay, you could also do a site-wide search of this site and find the answer. But if you are a lender, underwriter or analyst — for a bank or credit union or creditor — and you have that question, you have other important questions that need a more extensive review of tax return analysis.

With a higher % owner who has control over what she takes from the business, you might prefer to use cashflow available from the company instead of what she took the last couple of years. Obtain the full 1120s or 1065, determine company cashflow, and then give her credit for her share. This is where interest income received by the company will come in.

How low is low and how high is high?

Most lenders provide a guideline for determining whether you request only the K-1 or the entire tax return. Residential mortgage lenders often use a 25% threshold. SBA lenders often use a 20% threshold. I’ve seen as low as 10% and as high as 51%.

Check your guidelines to decide.

Common sense and judgment

Also consider what type of flexibility you are expected to exercise in the area of judgment and common sense. Are your guidelines more ‘guide’ or more ‘lines in the sand’. Even if the borrower owns less than 25%, if you know the underlying company is in trouble should you consider that? I can’t tell you the answer but you need to find out.

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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.