Patrick Asks
In your manual, Tax Return Analysis: Fundamentals and 1040, you state that interest from a partnership or S corporation can represent payments on a loan made to the entity and for which the borrower is receiving payments. Do you mean the borrower lent money to the entity? And by payments, do you mean principal and interest on the loan the borrower made to the company? How can I tell if it is pass-through interest or actual cash flow?
Linda Says
Interest listed from a partnership or S corporation on a Schedule B can represent several scenarios. If the taxpayer is not an owner, it means they either sold something to the company and are being paid on an installment basis, or they lent money to the company.
Identifying Ownership and Interest Types
When you first see the interest listed on Schedule B, you may not yet know if the 1040-filer is an owner of the company. If you know they are an owner, the possibilities expand. It could be a loan or installment payments on a sale, or it could be pass-through interest, which is not cash flow at all.
How Pass-Through Entities Work
Partnerships, LLCs filing a 1065, and S corporations are pass-through entities. They generally do not pay taxes themselves but pass the income, deductions, and credits through to the owner via a K-1 form. The owner then pays the taxes. Types of income passed through include:
- Interest income
- Dividend income
- Ordinary income
- Capital gains
Determining Pass-Through vs. Actual Payments
Some tax preparation software will label it as K-1 Interest, while others may use the name of the company. If labeled with the company name, you cannot tell by looking at the 1040 alone. If you have the K-1, check Line 2 (Interest Income). If it matches the amount on 1040 Schedule B, it is pass-through interest and does not represent cash flow to the 1040 taxpayer.
If you do not have the K-1, you will need to ask the borrower. Most lending and credit professionals doing tax return analysis to calculate global cash flow will obtain the K-1 if the taxpayer is an owner, allowing you to verify this information.
What to Do if It Is Not Pass-Through
If the interest is not pass-through, it is part of the payment on a loan or an installment sale. Only the interest portion of the payments is reported on Schedule B. You need to ask the borrower if they are receiving payments on a loan, note, or contract to find out the full payments received. Then, obtain a copy of the loan or note documents to verify the amount and duration of the payments.
If you have a Form 6252, check Line 21 to see how much principal was received. For those unfamiliar with these concepts, consider ordering the 1040 Manual for a comprehensive understanding.
Recommended Further Reading
For more insights, consider reading these related blog posts:
By understanding these nuances, you can better analyze tax returns and make informed lending decisions.
