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Cash Flow Analysis of K-1s: Count ordinary business income?

Can I use ordinary income?

Oscar asks:

My borrower is a 50% shareholder for a business filing a 1120S. The K-1 indicates $276,970 in ordinary business income and $176,914 in Distributions. I’m giving him the $176,914 distribution as real income for sure. However, I’m not sure if I should give him the full $276,970 due to the fact it is listed as Ordinary Business Income in Box 1 of the K-1. The borrower confirmed he took the whole $276K.

Linda says:

You have several choices. It may be a judgement call or based on your company guidelines. I doubt that he actually took the whole $276k. And I doubt that you can use it.

Actual vs Available

  1. Use the $176,914 distributions plus any W-2 wages he was paid from the company. It is common for S Corporation shareholders to take wages AND distributions because the company does not have to pay payroll taxes on the distributions.
  2. Use wages plus his share of available cash flow. To do this you must get the full 1120S. Yes, you already have his share of the ‘ordinary income’, but you do not have his share of depreciation to add back, company principal on debt payments to subtract, or other adjustments you might find. You cannot do this without the full 1120S, though.

Why get a full 1120S?

If we assume you are interested in the owner’s personal cash flow, some companies say you must get the full 1120S and give this person credit for 50% of the company cash flow. The idea in that approach is that what an owner takes home is not necessarily supported by cash flow from operations.

With just the K-1, we would not know if the company can afford the $176,914 because the company is doing well, or if they can afford it because the company sold off some assets, borrowed money or had an unusual windfall.

Other companies would say that if the company is not obligated on the debt, you cannot use cash flow available and must use what they have been paying. Their argument is that you can’t make the company come to the table just because one of the firm’s owners guaranteed your debt. In that case, you need at least two years and probably three years of K-1s to get an average. Or even, perhaps, take the lower of the there years. Again, remember that you are adding the distributions to the wages.

Consider % ownership

Some companies have a guideline based on % ownership. SBA requires the full return of any owner over 20% ownership. Most residential mortgage owners use 25% or higher. The idea is that, at that point, they have a bit more control of how much they get paid, but also that they are more likely to come to the table for that company if things go poorly. So it is important to see what kind of shape the company is in, in this case, since you are relying on the personal income from that company as part of your guarantor analysis.

Maybe you do not need a personal guarantee

Lastly, you indicated in your email to me that the funds are to buy an apartment building. Some lenders will modify their need for more information on the guarantor of the loan if the appraisal of the property compared to the amount of the loan provides for a loan-to-value below a certain level.

And they’ll look at whether the rents from the apartment building provide a strong enough debt coverage ratio without the owner/guarantor stepping in with his own funds. The stronger the deal without the guarantor, the less you might need to do the more thorough analysis of the guarantor’s company.

Time to talk

Perhaps with this info, you can have a quick but very informed conversation with your mentor/senior lender to decide what to do. Lay out the arguments I gave you for the various approaches and see what your company guidelines are. If the guidelines are not hard and fast, this is a good chance to learn how your mentor lender would use judgement to decide.

K-1s are a hot topic!

Need more help on k-1s? Truly, it is one of the most common questions I get here on the site, in my live webinars and in person training.