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Tax Return Analysis

When to use K-1 Pass-Thru Income for Personal/Owner Analysis?

Ron’s question:

I am a commercial real estate lender for a small bank. In the past I’ve always used the pass-thru income from real estate entity LLCs as part of the calculation of personal cash flow of a guarantor. I see that adding the actual cashflow from the K-1’s is much better, but what should I use when the there are no or small distributions or guaranteed payments to partners. In that case, is it better to use the pass-thru income of the LLCs?

Linda’s answer:

If I were queen for a day, I would never use pass-through income from a partnership or s corporation reported on 1040 Schedule E, Page 2 or the relevant form on a 1065, 1120 or 1120S. Why? Because taxable income is not cash flow. And only cash flow pays the business debt and/or the owner.

What to use instead?

I would use either actual cashflow (1065: guaranteed payments plus distributions less capital contributed or 1120S: distributions on k-1 Line 16 Code D) or cashflow available from an analysis of the full pass-thru entity return. Cashflow available requires you get the full entity return, do the cashflow analysis of the entity, and determine the individual owners percentage ownership.

Not everyone agrees with me

FNMA allows use of ordinary income when less than 25% ownership. And yes, I disagree. When you use pass-through in the absence of distributions, you are substituting taxable income for cashflow. Taxable income does not pay debt or the owners.

I recall a bank I worked with back in 2007 who insisted that they would use actual distributions if there interest was the individual, either as a borrower or a guarantor for a different loan, regardless of percentage. They required that the last 3 year’s K-1s show a similar amount.

You may recall that we went into the Great Recession in 2008. By the time those owners slowed down their distributions, the bank had been counting on them too long. BTW, that bank was one of the banks that failed in 2009.

More on Owner Cashflow from a Pass-Through Entity

Lenders Online Training on tax return and financial statement analysis

www.LendersOnlineTraining.com has three modules on 1065 analysis and three more on 1120S analysis. The third in each series focuses on owner cashflow.

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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.