Q: When the company shows loans to owners year after year and there are periods of cash distributions, are we to consider both distributions and loans to owners in our adjustment of net profit?
A: Yes. Reported net profit is adjusted by the sum of distributions and loans to owners.
For all non-subchapter C organizations – the subchapter S Corporation, the partnership, the limited liability company, and the sole proprietorship – the income tax obligation on the company’s taxable income is passed to the owner, or owners, and the owners get the money to pay the taxes from distributions and, often, loans from the company. Reported profit, the amount of profit that is reported on the financial statements, is over-stated by the amount of distributions and loans to owners.
Distributions provide cash to the owners to pay the income tax obligation of the non-subchapter C business organizations, and if the amount taken out of the company by the owners in the form of distributions exceeds the income tax obligation, and it frequently does, then the excess is compensation.
Loans to owners are really the same thing. Often we’ll see an account that is due from owners or due from stockholders. That’s an asset account. And these loans almost invariably turn out to be advance distributions. Like distributions, these loans are cash outflows.
These cash outflows serve two purposes: to pay income taxes and provide compensation. Both income taxes and compensation are operating expenses, and operating expenses belong on the income statement.
Course overview: Analytical Decision Tree and the Credit Write-Up