It is fairly common to find a Due from Shareholders account on the asset side of a borrower’s balance sheet and then a Due to Shareholders account on the liability side of the same balance sheet. Further, the balances in both accounts normally change from period to period.  Depending on the direction and magnitude of the changes, the shareholders or owners either put cash into the company or take cash from it on a net basis.  Consequently, it seems simplest to collect the changes in one location on the cash flow statement and designate that line item as either a) a cash inflow to the company, which decreases its financing requirement, or b) a cash outflow from the company, which adds to its financing requirement.

But it is not so simple.  There are two separate accounts because the cash flows into and out of these accounts take place for very different reasons.

• If an owner borrowers from his or her company – which increases the balance in the Due from Shareholders account – it is invariably to a) use the cash as an advance distribution to pay personal income taxes on company profit or b)  to use the cash for compensation – or both. 

• If an owner lends money to his or her company – which increases the balance in the Due to Shareholders account – it is usually to provide emergency financing in the absence of necessary financing from outside third parties.

We could argue, of course, that a loan by an owner to his or her company rightfully offsets and reduces, in theory if not in fact, the amounts he or she has borrowed from the company.  For example, assume a $100,000 balance in the Due from Shareholders account at the time an owner provides a loan to the company in the amount of $100,000, which increases the balance in the Due to Shareholders account by $100,000.  Shouldn’t we simply assume the $100,000 cash inflow was intended to eliminate the loan – even though the $100,000 balance remains in the Due from Shareholders account?

The answer is no.  If the owner had wanted to eliminate his or her loan from the company with a $100,000 payment to the company, he or she would have specified that the $100,000 was for the purpose of repaying the loan.  The balance in the Due from Shareholders account would have been eliminated by the cash inflow from the owner.  But the owner obviously had no intention of repaying the loan. Furthermore, by designating the $100,000 cash inflow to the company as a loan and not as a capital injection, the owner very definitely intends to be repaid the full $100,000 when the company has the cash resources to do so.

There are some further complications in interpreting movements in the Due from Shareholders and Due to Shareholders accounts.  If the balance in the Due from Shareholders account decreases, we quite naturally assume that the owner has repaid some or all of the money he or she has borrowed from the company. 

But the facts may be very different.  If the company in question is a Subchapter S corporation, partnership, limited liability company, or sole proprietorship, the reduction in the Due from Shareholders account may simply reflect the conversion of a loan to a distribution or withdrawal via a set of offsetting accounting entries,.  That is, the owner borrows from the company during the year either to make quarterly income tax payments on company profit or to increase his or her effective compensation.  At the end of the year, the internal bookkeeper or outside accountant decides to convert some or all of the loan balance to a distribution or withdrawal with a credit entry to Due from Shareholders, which decreases that account balance, and an offsetting debit entry to Distributions or Withdrawals, which decreases retained earnings or proprietor’s capital. 

The reduction in the Due from Shareholders balance does not reflect a cash repayment of some or all of the outstanding loan balance.  Quite the contrary.  Cash went out of the company to the owner when he or she borrowed the money initially that increased the balance in the Due from Shareholder account.  The subsequent reduction in the Due from Shareholders account reflected a non-cash event that converted some or all of the loan balance to a distribution or withdrawal.

For a Subchapter C corporation, a reduction in the Due from Shareholders balance will not reflect the conversion of loans to distributions, but it frequently reflects the conversion from loans to an owner to additional salary to that same owner.  In the conversion process, the company will provide the owner with the additional cash necessary to meet the tax withholding requirements on the newly provided “salary”.

Loans to owners and distributions or withdrawals, on the one hand, represent either income tax expense or compensation or both.  Regardless of how we classify these events in accordance with accounting conventions, they are operating expenses for the company and need to be recognized as operating expenses, which effectively decrease reported profit and decrease debt service resources.

Loans from owners, on the other hand, represents financing and, usually, emergency financing.  Such loans are not offsets or reductions to loans to owners but a very separate event with a very different objective. 

Consequently, it is critical in assessing the risk profile and the debt service prospects of a borrower that we fully acknowledge the fundamental difference between these two categories of cash flows.  One is an operating event, which belongs in the expense stream on the income statement and in the operating section of the cash flow statement.  The other is a financing event, which does not touch the income statement but, rather, belongs on the balance sheet and in the financing section of the cash flow statement.

In the Question and Answer segment of Webcast on Personal Income Tax Returns on September 3rd, we responded to the questions submitted.  However, we have repeated the questions (slightly edited in some instances) and have provided more detailed answers to each below.

Q: Why would we not use the actual cash received from the sale of stock versus the capital gain?

A: If we follow the conventional approach, we would use the cash capital gain as part of the cash revenue streams that ultimately sum to personal cash revenue. But it really makes more sense to use the amount of cash received from the sale of stock, rather than just the capital gain or loss component.  After all, we include loan repayments as part of cash revenue. This is really no different. 

Q: If a company accrues interest expense on a loan from a shareholder, but that expense is recapitalized rather than paid in cash, is that non-cash interest income for the individual reported on the personal tax return, and if so, is there any way to tell that it's non-cash from looking at the PTR.

A: If the company accrues interest due a lender, e.g., a shareholder, it would initially debit interest expense and credit an accrued liability account such as interest payable (rather than cash, assuming it has yet to pay the obligation in cash).  If it then capitalizes the interest expense, i.e., transfers it from the income statement to the balance sheet, it does so by a credit entry to interest expense (to remove interest expense from the income statement) and a debit entry to an asset account (very likely to an intangible asset such as financing charges or fees).  Over time, the company will amortize that asset and bring the interest expense back into the expense stream on the income statement.

From the stockholder’s perspective, he or she must report interest income based on the Form 1099–INT provided to him or her by the company, regardless of whether he or she actually received the interest income in cash.  If the company did not file and submit the Form 1099–INT, then the shareholder would very likely not report interest income from the company.

Whether the interest income amount were cash or not (assuming the company issued a Form 1099–INT and subsequently did capitalize the interest expense) is virtually impossible to determine from the personal income tax returns.  We would need to ask the shareholder if he or she did receive the amount in cash.  However, in general assume the interest income amount reported by the taxpayer is indeed cash unless you have a reason to suspect otherwise.

Q: How do you incorporate credit bureau information into personal cash flows?

A: In general, use credit bureau information to confirm or refute the amounts of revolving debt reported on a personal financial statement or stated by a borrower or guarantor on a lender’s format.  To be conservative, use the greater debt amount and estimate debt service on that amount, which is then included in the final section of a personal cash flow statement – the section that focuses on personal debt service obligations.

Q: Please explain the qualified non recourse financing and recourse financing section of the K-1.

A:  Qualified non recourse financing falls into a gray area between recourse and non recourse, i.e., full recourse to a guarantor versus no recourse to a guarantor if the primary obligor is unable to satisfy its debt service obligations.  If qualified non recourse financing is secured by real estate assets, then, in practical terms, it usually becomes recourse financing.  Therefore, when you see an amount listed as qualified non recourse financing, consider it an amount for which the guarantor would be fully liable in a crisis.

Q:  Why not use the federal taxes listed on schedule A instead of the 1040 statement?

A:  All the supporting schedules roll up into the amounts listed on the Form 1040.  There should be no contradiction between supporting schedule amounts and summary amounts on the Form 1040.  As general guidance, it makes sense to use the supporting schedules, e.g., Schedule A and associated statements, to determine the individual amounts that roll up into Form 1040 totals.

Q: Can you comment on the increasing use of TurboTax or other self prepared computer based returns and the accuracy of the Returns & associated Forms & Schedules vs. CPA prepared?

A:  On the surface, we should be concerned with the increasing number of TurboTax preparations in lieu of preparations completed by CPAs or other professionals.  But TurboTax, as one example, has a very impressive series of checks in place to assure that revenue and expense areas are properly addressed.  The bottom line issue is whether the tax payer declares all revenue. That might be easier to do if the taxpayer is preparing his or her own returns independent from the probing questions of a professional tax preparation expert.  On balance, though, if someone wishes to cheat on taxes, he or she can do it regardless of whether the taxpayer uses a software application such as TurboTax.