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When can I use Schedule E for Pass-thru entities?

Brent’s question:

I recently attended your Farm Credit training out in Lansing, MI. I am on the webinar right now with you and when you have time, I am hoping you can help me with the following.

I want to clarify, but think you said that you do not include any K-1 income, especially if it is “non-passive” and if you do not have the source return (actual K-1). Is it safe to say that I should not use either of these (below) in my analysis?:

Schedule E

-2010 Non-passive loss from K-1 of $178,045

-2011 Non-passive Income from K-1 of $75,938

-Client is 50% owner of partnership and we do not have full taxes

Do I include either, both, or none of these?

Thanks Linda!

Linda says:

Hello, Brent! Glad you were able to make the webinar. You have it correct…the numbers on the 1040 Schedule E, whether income or loss, are pass-through numbers. Here is why I do not use them.

Not cash flow…

If from a partnership return, we do not know if part of the number is guaranteed payments…which could be cash. But we do know it is, or includes, the partner’s share of taxable income. And that definitely is not cash.

Is it a partnership or an LLC?

Are you sure it is a partnership? When the Schedule E, Page Two list of pass-thru entities says ‘P’ or ‘S’ in the second column, that refers to the return, not the entity. A ‘P’ for partnership could indicate a general partnership, a limited partnership, a limited liability company or limited liability partnership.

This difference is important because if it is a partnership, and she is a general partner, then she has full liability for all partnership debts, contracts, lawsuits…the works! Some of my clients would always get the underlying 1065 for a general partner because of the higher risk.

One way to tell, did she put LLC in the name of the company?

Since it is on the non-passive side:

  • We know this partner (or LLC owner) is active in the business.
  • We know this is likely a general partner if it is a partnership
  •    o Limited partners would be listed on the passive side
       o A general partner could be on the passive side, but that would mean they were not active in the business. That is extremely unlikely for a general partner since they are 100% liable for everything, regardless of their % ownership.

Since she is a 50% owner:

  • It is likely that she has guaranteed debt.
  • She probably can control how much the partnership/LLC distributes to the owners, including to her.

What do you need and what do you use?

So…you really need the k-1 to see what she did take and the 1065 to see what the source entity can afford to pay. I would say none of those numbers you listed from the Schedule E for 2010 and 2011 would be useful, but you need to replace them with something you can use…preferably (strong preference) from the 1065.

Even if she were a 15% owner

That is below the threshold for many banks to require the underlying return, but I might want the 1065 anyway. Consider if the income from this operation is the most significant personal income she has. Or since this is a farming operation, perhaps for her adult children. If so, and with the swing between ($178,045) in 2010 and $75,938 in 2011, I would really need to see the underlying return to get a feel for what is happening in the operation. That would be the case regardless of what the K-1 tells me she is taking in guaranteed payments and distributions or contributing to capital.

Possible exception:

I have clients who will use the passive income/losses, if not large, instead of getting the K-1s. Their thinking is that the passive income/loss items are more like investments and unlikely to be a strong source of cash flow until they are sold. And since the numbers in question are on the passive side, they think the investors likely have liability limited to what they have already invested.

These are simplifying assumptions and I have no problem with them. The risk we always run with simplifying assumptions is that we are missing something that would make a difference in our loan decision. But the crafters of any guideline exceptions have hopefully taken into account the risk of that. A few examples…an investor may have a call provision to contribute more capital if needed. Or a limited partner may have been willing to guarantee a debt in order for the partnership to acquire needed financing.

It comes back to understanding and guidelines:

Everyone in on the loan decision needs a clear understanding of just what these numbers mean. And I suggest your financial institution develop clear, and well communicated, guidelines on just what to do with pass-thru entities (filing 1065 and 1120S returns).

A lot of confusion…thus the emphasis in the web-based class

By far, this is the area I get the most questions, and see the most confusion, on. Seven of the 21 online modules in my Web-Based Tax Return Analysis Class focus on just this topic. That, by the way, is a shameless promotion for the Web-Based Classes in case you did not notice. ‘-) Click here to get more info on the upcoming session.

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.