Tax Return Analysis Terms (of endearment?)

After each definition you’ll find a tip in italics about tax return analysis that will help you qualify your borrower.

Accrual Basis of Accounting

A system whereby revenue is recognized and recorded when earned (rather than when received) and expenses are recognized and recorded when incurred (rather than paid).

If the two or three year’s tax returns or financial statements you are reviewing are cash-basis instead, be careful comparing the years. The difference may just be timing of receipts and payments rather than a more (or less) profitable company.

Adjusted Gross Income

Gross income reduced by certain amounts, such as a deductible IRA contribution or student loan interest.

Many lenders reviewing a 1040 tax return use this as their starting number and then adjust it for noncash, nonrecurring, nontaxed, nondeductible, nondocumented or new gain/income or loss/expenses.


Money received from or paid to a former spouse under a divorce decree or separation instrument.

Most lenders need additional documentation before including alimony in recurring income. Consider leaving it out (taking it out if using the AGI method) if you do not need it to qualify the borrower. And if your borrower pays it instead of receiving it, see if you can subtract it from income instead of putting it on a debt list. Their debt-to-income ratio will be much better!

The bookkeeping write-off of intangible assets over their useful life.

Lenders can add this back in the same way you add back depreciation, and for the same reason.

Alternative Minimum Tax

A separate method for calculating income taxes. The tax payer is responsible for paying the higher of the AMT or the regular tax. If the AMT tax is higher, the difference between the AMT and the regular tax is added on the 1040 Line 45 (on the 2006 returns).

Many of the forms used to calculate the AMT are duplicates of a form you’ll already have reviewed in the normal course of your analysis. You can generally ignore the AMT version, which will say AMT at the top of the form, if you have already looked at the ‘regular tax’ version.


The increase in value of an asset.

Some lenders find it odd that on a tax return or financial statement, we ‘depreciate’ appreciating assets. That is because on the tax return, depreciation is a cost recovery concept, not a valuation concept. Likewise, a balance sheet (financial statement or schedule on a tax return) is showing the historical cost of the asset, not the appreciated value. You want to know what it is worth? Don’t look to the business financial statements.

Book Value

Historical cost of an asset less the depreciation accumulated against it.

Because the balance sheet assets on a corporation (1120 or 1120S) or partnership/LLC (1065) tax return are based on books and records, they are listed at historical cost. If the business is showing negative retained earnings (can we call them accumulated losses?), consider if some of the assets are Real Estate. If so, their ‘fair market value’ is likely much higher than their ‘book’ value.

Business use of home

Employees who work out of their home or business owners whose home is their primary office may be able to deduct part of their household expenses on their tax return.

The home office deduction for a Sole Proprietorship, 2006 Schedule C Line 30, is a calculated number, not an additional out-of-pocket expense. It is primarily made up of their house payment, which you are likely counting against them elsewhere in your tax return analysis. Most lenders add the home office deduction back when calculating cashflow from a sole proprietorship.

Capital contributions

Amounts contributed from owners (shareholders of corporations, partners or LLC members) to the capital of their company.

Consider if this is a continuing need for capital contributions, in which case you may need to count it against the owner/guarantor’s cashflow. If there is a significant capital contribution when the business is profitable, it may indicated upcoming plans for expansion of the business. Time for another visit to the company?

Capital expenditures

Business spending on additional plant equipment and inventory.

This is easiest seen on the balance sheets of corporations (1120 or 1120S) and partnership/LLCs (1065). Compare the beginning-of-the year to the end-of-the-year figures. If the capital expenditures are increasing, it may show a growing business. If the accumulated depreciation figures are approaching the asset balances, perhaps they need to make capital expenditures in the near future. If so, you may need to be careful not to max their borrowing capability out for the loan they are requesting from you. You may also find some other loan opportunities in their upcoming capital expenditures needs.

Capital Gain Distributions

Distributions from a mutual fund of capital gains on investments they have sold off.

This is likely to show up on the Capital Gains Schedule D but in fact, is just another variation of a dividend. Treat it like you do dividends, which is probably include in historical cashflow and assume it is continuing for recurring cashflow.

Capital Gains

The difference between what you paid for an investment/business/property and what you received when you sold that investment/business/property for more than your cost.

This is a tough one. The Schedule D shows the gain or loss, but does not show cashflow if it is a long-term gain/loss. If it is stock, you’d actually need a brokers statement to see the real cash impact in the current year of stock sales. And if it is real estate, you’d need the closing statement to see the net cashflow after they paid off their underlying mortgage or contract. Many lenders work to qualify their borrower without using the capital gains at all. If capital gains are integral to their cashflow, as is often the case with real estate developer/investors, you’ll likely need documentation/information beyond what is available in the tax return.

Capital Lease

A lease that actually represents the purchase of an asset. A lease is generally deemed a capital or financing lease when the item can be purchased at the end of the lease for 10% or less of the value.

When considering how soon a borrower may need to replace a leased item, we cannot assume they won’t end up with it after the lease and be able to keep it longer. This can be relevant if you are looking for more loan opportunities with this borrower and also if you are considering whether approving the loan requested will make it difficult to finance the purchase of equipment in the near future.

Capital Losses

The opposite of capital gains…you lost money.

See the entry at Capital Gains for tips. Also consider that a capital loss can camouflage positive cashflow. I buy stock for $100,000 in 2000. Sell it for $80,000 in the current year. Tax return will show a $20,000 loss. But what happened to the checkbook this year? A positive $80,000. Sometimes this is where that ‘missing income’ is hiding. You know, the borrower who seems to have no income but bought a yacht last year?

More C’s and D-Z…to be continued.

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