Q: Who pays the tax on the $64,424 excess distribution included in the total distribution of $88,145 made by Greater Pacific Realty Partners to Douglas McPherson?

A: No one pays taxes on the excess distribution of $64,424. Our estimate of federal income tax due on Mr. McPherson’s $122,969 pro rata share of Greater Pacific 2015 net earnings at his effective tax rate of 19.29% is $23,721. 2015 distributions to McPherson were $88,145, generating the $64,424 excess distribution, which are totally tax free to him. Distributions to include any excess are never included as ordinary income. Douglas McPherson does not report the $88,145 distributions – nor the compensation component of $64,424 – as taxable income on this Form 1040.

Q: Regarding the loan from shareholder, is the $20,085 on Schedule B the interest portion of the payments Sandover Contractors made to Mr. McPherson and the $86,863 reported on Line 16E of Sandover’s Schedule K-1 the principle portion of payments the company made to Mr. McPherson during 2015?

A: Yes. This can be validated by the fact that the unpaid balance on this shareholder loan reported as Notes Payable - Subordinated Debt on the company balance sheet declined by $86,863 to $110,554.

Q: Could you please expand on guaranteed payments? Why are they guaranteed? In what cases are they used and by whom? What are the consequences of the business not fulfilling their guarantee?

A: Guaranteed payments are like salaries in that a partnership is legally obligated to pay a partner the amount of the guaranteed payment regardless of whether the partnership is profitable. The guaranteed payment – unlike distributions – reduces a partnership's taxable business income.

Further, the partnership does not withhold FICA or Medicare payments from the guaranteed amount. The partner is personally responsible for making these withholding payments as well as for paying taxes on amounts received.

There are limitations on providing guaranteed payments, but, usually, they are provided to partners who bring unique skills or abilities to the partnership. In addition, note that health insurance costs incurred by a partnership on behalf of a partner are classified as guaranteed payments and are, consequently, tax deductible for the partnership.

Q: What is the difference of passive and non-passive income from K-1 on Schedule E Part II?

A: Passive income means that the owner or partner was not active in the operations or management of the business – a faceless outside investor, in effect. Non-passive income means that the owner or partner was indeed active in the operations or management of the business. As an example, in the case of McPherson, his rental income from the real estate partnership, Greater Pacific Realty Partners, is considered Passive, and his income from Sandover Contractors Inc. is considered Non-Passive.

The IRS provides specific guidelines for identifying and defining passive and non- passive income.

With respect to income tax implications, a passive loss can be used only to offset positive passive income but cannot offset positive non-passive income.

Q: Why is the $1,001 from the Coast Savings CD not included for either Cash Flow to McPherson or Taxable Revenue to McPherson?

A: The $1,001 from Coast Savings is included as a cash inflow to McPherson on the consolidated cash flow (see Slide 45) as part of the $21,086 cash inflow from interest income. Since the $1,001 was interest on a CD that McPherson held personally, it did not appear on the analyses of cash flow to McPherson from Sandover Contractors Inc. captured on Slide 34, as these cash flow analyses only included the cash inflows from the Subchapter S corporation.

Q: The initial slide in Step 6 (Cash Flows and Taxable Revenue Summation) does not incorporate the CD into the Cash Flow?

A: We did not include the $1,001 interest income from the Coast Savings CD in the $20,085 of interest income we listed on Slide 34 since we we listed only cash inflows from Sandover Contractors and not from other sources on that particular slide. The same holds with respect to taxable revenue. We listed only taxable revenue from Sandover Contractors in the form of salaries, interest income, or the owner's share of taxable business income.

Q: We usually do not count capital gains as income for a borrower, mainly because these are usually one-time gains and are not ongoing. What are your thoughts on that?

A: For historical purposes, we count the net cash inflow from the sale of assets that give rise to the gain or loss. Assuming a positive net number for the period, i.e., cash outflow to purchase the asset (assuming the purchase took place in this period; otherwise no cash outflow in this period) and cash inflow from the sale of the asset, we count that as cash revenue for the period. It happened, in effect, and we do not want to ignore it.

But, going forward, we generally excluded projected capital gains or losses, since, as you suggest, they are frequently non-recurring or, if recurring, are extremely difficult to project.

There are borrowers that have capital gains on a recurring basis due to the nature of their business or, perhaps, their investment portfolio. The historical analysis combined with a review of their financial statements could support a case for inclusion of capital gains (and losses) for these borrowers. Many institutions address the handling of capital gains in the credit policy, excluding capital gains from cash flow projections as standard treatment, with inclusion the exception for those borrowers.

Q: From time to time, Line 13 on Schedule D will have capital gain distributions. Are they “cash” received or not?

A: In general, these are long-term capital gains associated with the performance of various investments in a fund of some nature. Technically, the cash gain is posted to the fund balance, which the investor may take as he or she wishes. But the cash gain itself does not, in general, flow directly to the investor but, instead, it goes to his or her fund. In effect, the technicality should be overlooked since the distributions of these capital gains to the fund are really cash inflows immediately at the disposal of the investor and taxpayer.

Q: How do you determine if an amount report at Line 8b on 1040 is actual cash flow or not?

A: Line 8b reports tax-exempt interest income. Assume tax exempt interest income is cash unless there is evidence to the contrary. Usually, such income is associated with investments in tax-exempt municipal bonds. Depending on the detail provided in the income tax return, there may be a statement that clarifies the amount listed at Line 8b. In the case of McPherson, there is a description of the tax-exempt income in Statement 2 attached to his tax return. However, you need to review the Schedule K-1s for any evidence that it is not cash flow to the taxpayer.

If it were non-cash income flowing to the taxpayer for reporting from a partnership, it would be listed on the Partnership Schedule K-1(form 1065) at Line 18 – the line titled “Tax-exempt income…” on the 1065. It would be coded A for tax-exempt interest. If it flowed from an LLC or Subchapter S corporation, it would be included on line 16 on Shareholder Schedule K-1 (form 1120S), the line titled “items affecting shareholder basis.” It would also be coded with an A denoting that it is reporting tax exempt interest. (Please note the codes are all listed and defined on the second page of the Schedule K-1 forms.) If the tax-exempt interest income is flowing from a Schedule K-1, it is interest income that was cash to the entity and it is not cash flow to the taxpayer.

Comment: His shares of crappy GE stock are now only worth $1,619.

Response: This comment about the “crappy GE stock” points out the importance of using current bank, broker, or financial advisory statements to assess ready cash from month to month rather than relying on an annual personal financial statement. In a volatile market, validating the current values of stocks may be prudent if they are substantial or material to the transaction.

Q: Please recap on how you arrived at $345,245 in cash from Sub Chapter S?

A: The $345, 245 in cash from the Subchapter S corporation listed on the Personal Cash Revenue template on Slide 45 is comprised of distributions of $251,575, loan repayments of $86,863 (these two sources of cash were pulled from Line 16 on the Schedule K-1 for Sandover Contractors) plus the $6,807 loan made by Sandover Contractors to Douglas McPherson based on a review of the company’s balance sheet.

The loan amount of $6,807 is calculated using the difference, year over year, of the balance in loans “Due from Stockholder.” The increase in the “Due from Stockholder” amount equaled $6,807 representing loans paid out in cash to Mr. McPherson in 2015.

For reference, the total reconciliation of cash paid to Douglas McPherson is on Slide 45. The $345,245 is the last amount listed in the Cash column. The detail for these three amounts totaling $345,245 is on Slide 34. In addition to the $345,245 recorded on both slides, there is also $210,000 in wages and salaries plus $20,085 of interest income paid by Sandover Contractors to Douglas McPherson resulting in $575,330 of total cash flow from Sandover Contractors to Douglas McPherson (Slide 57).  

Q: Where did you get the additional $6,807 in income that you noted was not on the tax return or reported on Schedule K-1?

A: This amount came from the balance sheet for Sandover Contractors Inc., which shows an increase in “Due from Stockholder” of $6,807.  

Q: So you would add the amounts reported at Lines 8a and 8b together for actual cash flow offset by any business interest income?

A: Yes. You would add the amounts reported at Lines 8a and 8b together for cash interest income, then deduct any interest income that flows from the Schedules K-1. Any interest income reported on the Schedules K-1, both exempt and non-exempt, is business cash flow, not personal cash flow.

Q: Can you send the answers for all polls please?

A: Absolutely. We send the poll answers after each session, you'll find it linked within the follow-up email.

Q: I understand we do not count interest or dividends (Schedule B) from K-1’s as cash flow for a guarantor. My question is, does this also apply for LLC’s?

A: Yes. It does apply. Any amount reported as interest or dividend income on a taxpayer's Schedule B that comes from a Schedule K-1 represents the taxpayer's pro-rate share of interest or dividend income received by the LLC, partnership or Subchapter S corporation. It is cash to the company but not cash to the taxpayer.

Q: Is it possible for a K-1 (for which the entities’ purpose is used to collect rent) to not report rental income (no distributions taken from entity), while a personal financial statement shows rental income from those properties?
 
A: Such an entity could, conceivably, run at a break-even rate such that there was neither income or loss reported by the entity on Schedule K-1. If profit turns out to be exactly zero, then Schedule K-1 would report zero dollars as the taxpayer's pro-rate share of the zero profit.

But if the entity did report a profit or loss, it would pass on the taxpayer's pro-rate share or either the profit or loss via information in Schedule K-1. And it is certainly possible, and does occur, for such an entity to report a profit and report the taxpayer's pro-rate share of the profit on a Schedule K-1 but then fail to distribute any cash to the taxpayer. In such a case, the taxpayer should record rental income on a personal financial statement (PFS) but there should indeed be similar amount reported on a Schedule K-1, regardless of whether the entity provided cash distributions to the taxpayer.

It might be possible, too, that the rental income on the PFS represents rental income from properties held personally by the taxpayer and reported on Part I of Schedule E in his or her personal income tax returns. On the surface, the combination you describe sounds unusual, but perhaps there is a valid explanation.

Q: In my experience, non-recourse lending is just that, non-recourse. So the only recourse to the lender would be to the collateral on a non-recourse debt to the a general partnership, and the individual partner would not be liable.

A: There are two issues in the McPherson case. The first is the maximum tax loss McPherson could claim and the second is the amount of partnership debt for which he is liable as a general partner.

Given the definition of "qualified", McPherson's pro-rate share of the qualified non-recourse financing - 40% - sets the upper limit of his "at risk" basis should the partnership default on the debt. In other words, it sets the maximum loss he could claim for income tax purposes.

However, since McPherson is a general partner in the partnership, he is responsible for the full $2,565,025 of qualified non-recourse financing.

Whether "qualified" applies to the full $2,565,025 as events unfold likely reflects California's single action rule, which allows a lender to take legal action to acquire real estate collateral in the event of default or to take legal action against a guarantor. The lender must choose one or the other courses of action but is precluded from pursuing both simultaneously. Hence at the outset of a term real estate transaction, it is unclear if a general partner will ultimately be on the hook for the full amount of the financing should an event of default occur. He or she may or may not, depending on the lender's choice of action.

Q: Please define the term "pass-through".

A: The term “pass-through” in this context refers to those businesses that do not pay federal income taxes for themselves. Income taxes are instead paid by the owners or partners in the business per IRS guidelines.

Businesses included in this category are Subchapter S Corporations, Partnerships, Limited Liability Companies, and Proprietorships. These entities (except for proprietorships whose results are reported on the Schedule C included in the owner’s 1040 package) submit an “information only” business tax return to the IRS that identifies net income that would otherwise be taxable to the business. Instead of paying income taxes on their earnings defined in this way, these entities report the taxable earnings to owners or partners on a pro-rata basis using the Schedule K-1 and, in this way, “pass-through” the responsibility for taxes to the owners or partners.
 

Q: If a borrower is signing with recourse on a commercial loan is it recorded in Schedule K-1 (Form 1065) at Line K?

A: Yes. It would be recorded in in Part II at Line K in Schedule K-1 (Form 1065).

However, we need to remember that the Schedule K-1 (Form 1065) only records the partner’s pro-rata share of recourse debt which is used for “Basis” and “At Risk Loss Limitation” calculations. This means that the total recourse debt for which the partner is responsible may be higher than the amount shown on the Schedule K-1 (Form 1065).

Q: Is the $581,746 distribution a return of capital and, therefore, the owner pays no taxes on this amount?

A: Distributions from a partnership to partners have two purposes – to allow partners to pay the income tax obligation on partnership profit and to provide partners with compensation. A partner may also take compensation in the form of guaranteed payments, but that arrangement is not always attractive to all parties.

For a vast number of partners, the sole source of compensation is via distributions.  As a result, it doesn't seem appropriate to consider distributions a return on capital but, rather, as a two-part expense payment – one part for income taxes and the other for compensation.

The distribution is not taxed if it does not exceed a partner’s “Basis” in the partnership.

Q: If the distributions in this example are used by partners to pay for tax obligation on partnership profits, would the tax obligation be calculated on line 25 of Form 1120S? If the distribution is to provide partners with compensation wouldn’t this be reported on either a W-2 or 1099 and isn’t the compensation also reported on line 7 of Form 1120S?

A: The total amount of taxable income owners or partners must report on their personal income tax returns is a summary account on Schedule K or the amount reported at Line 8 on Schedule M-1 (Form 1120S) or at Line 9 on Schedule M-1 (Form 1065). For the owners of Information Access, Inc., the total taxable income in 2015 was $109,704. Since Peter Keys owns 82% of the company, he would report 82% of that amount, which is detailed on his Schedule K-1 (Form 1120S). In 2015, his pro rate taxable income from Information Access, Inc. was $91,967 of ordinary business income reported at Line 1 in Part III plus $345 of interest income reported at Line 4 minus $2,355 of charitable deductions reported at Line 12A. The sum of those three amounts is $89,957, which is 82% of $109,704 - the total taxable income generated by the company and passed to its owners.

There is nothing computed or calculated at Line 25 on Schedule 1120S (the first page of Form 1120S) for two reasons. First, the income tax obligation is passed to the owners. Second, the owners include their share of taxable company income on their Form 1040 along with all other taxable income that the owners must report The owners total income tax obligation, therefore, is the sum of all taxable income reported on Form 1040. The applicable income tax rate will depend on the tax bracket associated with the final amount of total taxable income less all deductions and credits. In the case of Peter Keys, his effective income tax rate in 2015 was roughly 15% - or total tax of $50,540 reported at Line 63 on his Form 1040 divided by his adjusted gross income reported at Line 37 on Form 1040. If the company were to provide distributions for his income tax obligation on $89,957 of the company's taxable income, it would provide 15% of $89,957 or about $13,500. Instead, the company distributed $581,746 in cash to Peter Keys in 2015. The vast majority of that distribution was compensation.

Note that, given IRS regulations, Peter Keys does not report distributions on his Form 1040 as taxable revenue - regardless of the purpose of the distributions. Distributions are not captured or reported on a W-2, or a 1099 or at Line 7 on Schedule 1120S. They fall outside of the income tax regime. As far as both personal and business income taxes are concerned, distributions are a non-event. In this sense they are identical to loans to owners, since loans to owners are not reported as income on a W-2 or 1099 or reported in any fashion at Line 7 on Schedule 1120S. Further, neither distributions or loans to owners can be classified as a tax deductible expense in compiling accrual net income or in compiling ordinary business income on Schedule 1120S or on Schedule 1065.

Q: Does Schedule L and Schedule M-2 summarize the owner or partner’s “Basis” in the company?

A: No. “Basis” for a partner is his or her pro-rata share of the accrual net worth plus his or her share of partnership liabilities for which he or she is at risk. The relevant information for a partner is reported at Lines K and L on Schedule K-1 (Form 1065). Schedule L does not identify the individual partnership liabilities for which a partner is responsible.

For an owner of a Subchapter S corporation, “Basis” is the pro-rata share of the accrual net worth plus any loans made to the company by the owner...Schedule M-2 does not provide the relevant details per owner nor information about the owner’s capital investment in the company. Schedule L reports loans from owners - the other piece in “Basis” in addition to owners' net worth in the business – but does not break out the loans by individual owner.

In order for one to see the actual computations for one’s “Basis” in a company, it would be necessary to obtain the working papers of the accountant.

Q: What did you mean by net worth reconciliation and distribution?

A: Distributions for an owner or partner are reported on Schedules K-1 (Form 1065) or on Schedule K-1 (Form 1120S). However, it is also possible to determine the total distributions from the company by reconciling the net worth from one year to the next.

Q: It looks like the first part of Schedule E shows that there is a passive loss on rental real estate, but the Schedule K-1 (Form 1065) shows it as income. Is the Schedule E incorrect?

A: Schedule E is correct.

The $35,774 is Peter Keys’ pro-rata share of passive income from Information Access Partners that can be fully offset by passive losses from rental properties reported in Part I on Schedule E.

Please note on Schedule E / Part I that Peter and Jennifer Keys own three rental properties in California which, at Line 21, show passive losses of $20,878, $30,417, and $70,159, respectively. The total of these three passive losses is $121,454.

The passive losses on Schedule E / Part I of $121,454 can be written off against the passive income of $35,774 from Information Access Partners on Schedule E / Part II, but only to the extent of that passive income amount. That is Peter Keys can use only $35,774 of total passive losses of $121,454.

Q: Why is investment interest income not taxable? Is this always the case? And if not when is it taxable? In the course - Identifying cash from rents on Sched E available to service the debt . . . Interest expense and depreciation are considered non cash. Can you explain in more detail why Interest expense is considered non-cash? I realize it is not an actual cash outlay, but there were people in our group that disagreed on whether it should be considered cash or not.
 
A: In constructing the personal cash flow for Douglas McPherson, we computed the amount of cash from his rental property reported in Part I on Schedule E that would be available to service interest-bearing debt. As a result, we deleted depreciation expense from the list of expense in Part I since it is non-cash. We removed interest expense, because we use it and principal repayments in the final section of the personal cash flow statement. Therefore, the amount of cash received by McPherson from his rental properties available to service interest-bearing debt in 2015 was $68,330. Then in the Personal Debt Service section of McPherson's personal cash flow statement, we included both the interest expense and principal repayment - $79,884 - on the loan supporting the rental property.  Since the interest expense amount we removed from Part I on Schedule E was $61,338, the principal repayment on the loan supporting the property was $18,546. That is, $61,338 + $18,546 = $79,884, which is the mortgage payment on McPherson's investment property reported on his personal financial statement.

The interest expense of $61,338 is definitely a tax-deductible expense and was used as such in computing the bottom line profit or loss from the rental property in Part I on Schedule E, which flowed into the final amount of taxable income reported at Line 41 on Schedule E and carried to Line 17 on Form 1040.

 

Q: Do owners take the distribution reported on their Schedule K-1 all at once or do they take them periodically throughout the year?

A: The frequency with which owners or partners take distributions depends on the company and on any agreements between the company and the owners / partners. If owners or partners rely on distributions as a main source of compensation, expect to see distributions taken a periodic basis, e.g., monthly. The ownership team’s cash appetite and management philosophy are often the key drivers in determining the frequency of distributions.

Q: Please explain why the Information Access Partners income is considered to be passive income when entered to the Schedule E.

A: The IRS has issued specific rules that determine if income is considered passive or nonpassive. The primary driver in characterizing income as nonpassive is that the partner or owner are active in managing the business. If not active in the business, the income or loss is considered to be passive.

An additional consideration is that real estate-related income is generally considered to be passive regardless of the involvement of the owner or partner. The difference between nonpassive and passive income also has implications for using losses to offset income. A passive loss can be used only to offset passive income and the loss allowed cannot exceed the amount of income for the period.

Q: How are guaranteed payments from closely held companies reported on the personal income tax return?

A: Guaranteed payments are unique to partnerships and are paid to partners under the terms of the partnership agreement. Each partner then reports the payments on Schedule E / Part II in his or her personal income tax returns. Note also that the receiving partner – not the partnership – is responsible for estimating and paying income taxes on the guaranteed payment earnings, the self-employment tax on those earnings, and all payroll taxes associated with the guaranteed payments.

Q: Where in the balance sheet does it show the $6,807 loan from the company to McPherson?

A:  The $6,807 in new loans from the Sandover Contractors, Inc. to Mr. McPherson during 2015 is derived from the current assets section of the company’s balance sheet.

The Due from Stockholders account increased from $20,290 at year end 2014 to $27,097 at year end 2015. That is an increase of $6,807 during the year and reflects new loans and company-originated cash flow to Douglas McPherson as sole owner during the year.

This transaction reminds us to be diligent in seeking out cash flows to owners by researching all the financial documents we receive from the borrower and guarantor. The Schedule K-1 is an important source of this information, but as we see here, it is not all-inclusive.

Q: Sometimes on partnership Schedules K-1, we see the figure reported in Part II / Line L for withdrawals and distributions but this amount is different from distributions reported on Part III / Line 19A. Is there a reason?

A: The two amounts should match. If not, it makes sense to ask the company or its accountant why there is a difference in the two amounts.

The Schedule K-1 issued by the partnership present each partner’s share of the distributions made during the year and the amounts reported in the two areas you cited must match if the identified partner’s capital account (and ultimately the partnership capital account) is to be fully reconciled.  

Q: Mr. McPherson’s 2015 total federal income tax due reported on Line 63 of his Schedule 1040 is $117,296, yet his total cash taxes for 2015 is $304,955. How do we reconcile the difference?

A: The $117,296 is the amount of federal income tax Mr. McPherson owed on his 2015 taxable income. The $304,955 represents the total amount of all 2015 cash taxes Mr. McPherson paid at all governmental levels and for all purposes as depicted below:

Note that in preparing his 2015 federal income tax return, Mr. McPherson used the combined Federal Withholding ($40,905) and Estimated Payments ($80,000) totaling $120,905 as displayed above to pay the total federal income tax of $117,296. He, in turn, realized a refund of $3,609 in settling his federal income tax liability.

Bottom line is that the $117,296 2015 federal income tax is a component of the $304,955 total for cash taxes paid 2015. The federal income tax is combined with the other taxes Mr. McPherson paid at all governmental levels for all purposes to arrive at the total for 2015 cash taxes paid, which includes$79,434 of taxes due from the prior year that were paid in 2015.

Q: Where is the $6,807 of new loans cited on Slide 34 Cash Flows and Taxable Revenue Summation reported in the webcast handouts?

A: The $6,807 in new loans comes from the Sandover Contractors, Inc. 2015 Balance Sheet.  

Due from Stockholders account is presented as a Current Asset account and the account increased from $20,290 at year end 2014 to $27,097 at year end 2015. That’s an increase of $6,807 during the year and reflects new loans and company-originated cash flow to Douglas McPherson as sole owner.

This transaction reminds us to be diligent in seeking out cash flows to owners by researching all the financial documents we receive from the borrower and guarantor. The Schedule K-1 is an important source of this information, but as we see here, it’s not all-inclusive.

Q: Interest income reported on Schedule K-1s flows through to the personal tax returns to be taxes, but does not represent actual cash income received by the individual. Is it the same for dividends?

For example, if we only have K-1s for an S-corp that report ordinary and qualified dividends in boxes 5a and 5b and correspond to dividends reported on Schedule B of that shareholder's personal tax return, this only represents pass-through income for the shareholder reported on the personal tax return only for taxation purposes and not because the individual actually received this dividend income, correct?
 
We have the same question for 1065 K-1s from partnerships for boxes 6a and 6b. We just want to confirm that dividends reported in these boxes is pass-through only and not actual cash movements from the business to the partner/shareholder.

A: Your understanding about about dividends is correct. If a Subchapter S corporation or partnership reports an owner's or partner's share of dividend income on his or her Schedule K-1, it represents the individual's taxable dividend income. However, the owner or partner did not receive a cash dividend payment. Rather, the company or partnership received cash from the dividend payment and passed the income tax obligation on dividend income to the owner or partner..

The company or the partnership provides distributions to the owners and partners to pay the income tax obligation on all taxable income generated by the pass-through entity. Such taxable income would include ordinary business income, interest income, dividend income, gain on sale of asset, etc. Frequently, the distributions exceed the owner's or partner's total income tax obligation on all sources of company or partnership taxable income - especially for a partnership. In such instances, the distributions serve to pay income tax on the taxable partnership profit as well as partner compensation.

Q: Regarding Slide 48, why is the $35,774 loss from the rental properties reported as income in Schedule E / Part 2. Shouldn't it be in Column f as Passive Loss Allowed?

A: The $35,774 is Information Access Partners’ passive income that can be fully offset by passive losses from rental properties reported in Part I on Schedule E.

Please note on Schedule E / Part I that Peter and Jennifer Keys own three rental properties in California which, on Line 21, show passive losses of $20,878, $30,417, and $70,159, respectively,) which total to passive losses of $121,454 for those three properties.

The passive losses on Schedule E / Part I of $121,454 can be written off against the passive income of $35,774 from Information Access Partners on Schedule E Part II, but only to the extent of that passive income amount, i.e., only $35,774 of the passive losses of $121,454 can be used this year.

Q: We use the Buker Tax Analysis program, and they say to use only cash distributions in cash outflow calculations. Do we count the $86863 loan repayment to the owner as cash flow?

A: Yes. The $86,863 loan repayment to McPherson was a cash inflow to him. It added to his cash revenue and should be a contribution to his personal cash flow for the year. In addition, it is cash taken out of the business, which diminishes the company's cash resources available to service its debt.

Our task is to identify all sources of cash revenue to the owner, and chief among those are salary, distributions, new loans to owners as well as any cash repayment for loans previously made to the company by the owner. In all of these examples, cash is taken out of the business that cannot be used to service company debt.

Q: Is it a red flag when a borrower continues to take distributions when the capital account is shown as a negative balance?

A: Absolutely. The amount of cash taken out of a company by an owner in any form (salary, distributions, loans to owner, and/or repayments to owners for loans previously made) is cash out of the company that cannot be used to service debt.

Moreover, these cash flows negatively affect net worth and can seriously inhibit the company’s ability to grow. It is also important to know that all of these cash outflows, except salary, are tax free to the recipient.

The exception is that any distribution which exceeds one’s basis in the company (defined to be the owner’s pro-rata share of the company’s accrual net worth plus any owner loans made to the company in the case of a Subchapter S corporation) are taxed at the capital gains rate.

Q: Regarding Poll Question 5, aren’t guaranteed payments to a partner and reported on the Schedule K-1 cash payments taxable to the partner? Does the receiving partner not report guaranteed payments on his or her personal 1040 tax return?

Poll Question 5 is as follows:

“All amounts reported on Peter Keys’ Schedule K-1 (Form 1065) that flow to his personal income tax returns are non-cash, while none of the cash amounts – now or in the future – reported on his Schedule K-1 (Form 1065) flow to his personal income tax returns.

Agree or Disagree.”

A: Our online response to this question (Agree) created some confusion for which we apologize. Although we corrected ourselves while still online, we would like to explain a little further. In the context of Mr. Keys’ tax return, it’s important to note that he received no guaranteed payments during 2015 and none were reported on his Schedule K-1. Since the only taxable income line item reported (Net Rental RE Income) generated no cash payment to Keys, this is indeed a statement with which we agree. That view is reinforced by the fact that Distributions paid in cash during 2015 created no income tax liability for Keys. This combination of circumstances is unique to Mr. Keys causes us to agree with the statement.  

As a general rule this is, however, a statement with which we disagree. Guaranteed payments are made in cash to the receiving partner(s) and are taxable to each receiving partner for the period in which received. In this general scenario, the guaranteed payments that are reported on the Schedule K-1 contradict the Poll Question 5 statement causing us to disagree.   

In further description of guaranteed payments to a partner, they are considered to be an operating expense and reduce the partnership’s net profit by the amount of the payment. Payments are, in turn, considered taxable income to the recipient and are reported through Schedule E to that taxpayer’s Form 1040. The partnership does not withhold income tax, social security, or Medicare from guaranteed payments. The receiving partner(s) must pay self-employment tax in lieu of withholding for income, social security, and Medicare.

Q: Can one partner receive a distribution reported on Schedule K-1 Line 19 A without another partner taking one? If so, can a Subchapter S shareholder claim a distribution even if other shareholders do not do so?

A: Yes to both situations. The payment of distributions is driven by the Partnership Agreement or Corporate Charter and Bylaws. Individual partners or shareholders may decline a distribution, or may not be offered distributions for various performance reasons, while others may choose to accept distributions as a primary source of compensation.

Q: You just said that distributions could be taxed if they exceeded the owner’s interest in the company.

A: That is true. If distributions exceed one’s basis in a Subchapter S Corporation, any excess would be taxed at the existing capital gains rate like any other capital gain from the sale of assets.

For a Subchapter S Corporation, one’s basis is defined to be the shareholder’s pro-rata share of the GAAP accrual net worth plus any loans made to the company by the shareholder.

According to IRS guidelines and regulations, an owner of a Subchapter S corporation and a partner in a partnership are responsible for paying income taxes on his or her pro-rata share of taxable company or partnership income. The owner’s or partner’s remaining profit after paying the income tax adds to his or her net worth in the business. Distributions from the Subchapter S corporation or from the partnership to an owner or partner represent a reduction in his or her net worth in the business. Since the retained profits have already been taxed, a tax on distributions would represent a second income tax on the owner’s or partner’s share of profits.

A more thoughtful view of why distributions are not taxed may have to do with the fact that they may be considered a return on capital which has already been taxed since distributions are charged to the company’s retained earnings. As distributions are paid, the individual owner’s or partner’s ownership basis is, in turn, reduced by a like amount. As a result, when cumulative distributions exceed the owner’s cumulative basis, or net worth, in the company, any additional distributions become taxable at capital gain rates.

Q: Can you shed some light on Schedule E / Part II with respect to the passive vs non-passive income issue?

A: Active income is income from any of the following:

• Wages, salary, commissions, bonuses, or other payments for services rendered.
• Profit from a trade or business in which the taxpayer is a material participant.
• Gain on the sale or other disposition of assets used in an active trade or business.
• Income from intangible property if the taxpayer’s personal efforts significantly contributed to the creation of the property.

Passive income is income from any of the following:

• Any trade or business or income-producing activity in which the taxpayer did not materially participate.
• Subject to certain exceptions, all rental activities, whether the taxpayer materially participates or not.

In general, if a taxpayer receives income (or losses) from a business but is not an active participant in the business, the income or loss is classified as passive income or loss.

An additional important consideration lies in the fact that IRS guidelines require that passive losses cannot exceed passive income just as non-passive losses cannot exceed non-passive income for the year. This guidance is very important in the event multiple business entities or similar personal business activity (as we saw with Mr. McPherson) are being reported.

Q: Isn't the Section 179 Deduction a form of accelerated depreciation?  Many Subchapter S corporations use it instead of Modified Accelerated Cost Recovery System (MACRS).

A: Yes the Section 179 Deduction is a form of accelerated depreciation.

The amount of a Section 179 Deduction is determined by the reporting company’s acquisition of qualified fixed assets during the tax year, up to $500,000 in 2016. The deduction is used exclusively by the owners to reduce their share of the company’s taxable business income. It is never included as a business expense by the company. The IRS regulations specifically prohibit the reporting company from including the deduction in its array of allowable business expenses.

Therefore, the amount of the Section 179 Deduction cannot be used to reduce the company’s ordinary business income. It may only be used by the owners to reduce their pro-rata share of taxable ordinary business income “passed through” to them by the company.

Note that non-Section 179 Deduction assets on a company books are subject to other accelerated methods of depreciation such as MACRS.  That is, fixed asset purchases that qualify for the Section 179 Deduction – purchases up to $500,000 for 2016 as noted above – are not included in fixed assets subject to MACRS depreciation. Depreciation expense for non-Section 179 Deduction assets is a) reported on Form 1125-A and included in Cost of Goods Sold reported at Line 2 on Schedule 1120S or b) reported at Line 14 on Schedule 1120S.

For further information, consider attending our session devoted to The Section 179 Deduction.

Q: Shouldn't the estimated payment be netted from the prior year liability?

A: No. Estimated tax payments in 2015 should not be deducted from the prior year tax liability.

We are calculating the cash flow impacts in the 2015 calendar year and, therefore, the estimated payment of $80,000 for 2015 is cash out in the year in question, and the prior year amount owed of $79,434 as of December 31, 2014 would actually be paid in 2015 as well.

Q: Please repeat for answer for Poll Question #8.

A: Poll Question #8 is as follows:

“The $35,774 of net rental real estate income reported on Peter Keys’ Schedule K-1 (Form 1065) flows to Schedule E in his personal income tax returns but is not reported at Line 17 on Form 1040 since it is a non-cash amount.
Agree / Disagree”

The correct response is to disagree with this statement. The net rental income of $35,774 is reported on the Schedule E, and is included in the amount reported at Line 17 on Mr. Keys’ Form 1040 despite the fact that it is a non-cash amount.

Q: Please confirm that a loan to the company from a Subchapter S corporation shareholder increases that shareholder’s basis, but a loan from a partner to the partnership does not?

A: Yes. A loan from a Subchapter S corporation shareholder increases his or her basis while a loan from a partner to a partnership does not affect the partner’s basis. Keep in mind that these rules are set by Congressional legislation (not by GAAP) and implemented by the IRS.

Q: What is the significance of the qualified non-recourse financing vs. recourse financing? $1,783,969 was reported for Mr. Keys as an Information Access Partners partner and $391,603 reported for Mr. Smith.

A: Qualified non-recourse financing is a designation assigned by the IRS regulation and defines partnership debt that, in the estimation of the IRS, a partner is not responsible for. The debt identified in this manner in a legal sense is recourse financing for which the partner is indeed directly responsible to pay. In other words, the partner is on the hook for the amount of qualified non-recourse financing. But if it were simple non-recourse debt in the eyes of the law, then the partner has no liability.

 

Q: Why isn't the $127,741 amount on Line 32 on Peter Keys’ Schedule E / Part II carried forward to Line 41 Schedule E / Part V?

A: The $127,741 on Line 32 represents the combined taxable earnings of Mr. Keys’ from Information Access, Inc. and Information Access Partners. Included in that total is the passive income from Information Access Partners, defined by the IRS as real estate income (as is the case of Information Access Partners) or earnings from a business in which the taxpayer is not playing an active role.

The net amount reported on Line 41 includes the combined earnings of the Subchapter S corporation and the partnership and the net income or loss from personally owned rental real estate reported in Part I on Schedule E at Line 26. Mr. Keys’ personally owned real estate generated a loss of $121,454 as reported on Part I at Line 21. Since the IRS defines these results to be passive real estate losses that cannot exceed any passive earnings, the net loss Keys can claimed in 2015 is “maxed out” at $35,774, the amount of his passive earnings from the partnership reported in Part II at Line 28A.

When all is said and done, the passive earnings in Part II at Line 28A were fully offset by the passive losses in Part I at Line 26 netting out to the $91,967 reported on Line 41 in Part V. Going a step further, note that if no passive income is reported, a passive loss cannot be claimed. In this case the total passive loss per Part I was $121,454.

Q: How do we know that $36,456 was a non-cash capital gain to Greater Pacific Realty Partners?

A: The $36,456 was a cash gain to the partnership, but it was a non-cash transaction to Douglas McPherson who was required to pay taxes associated with that gain on his Form 1040.

Q: How much of Schedule D capital gains is actual cash to McPherson?

A: Information on Schedule D Capital states that Douglas McPherson paid taxes on total capital gains of $40,697 – $4,241 on long-term capital gains from the sale of personal investments and $36,456 on long-term gains from the sale of property by Greater Pacific Realty Partners. As Line 8a column (d) indicates, the cash proceeds from the sale of personal investments was $18,285.

Q: Why do you add back interest on Schedule E Part 1 if that is money out of his pocket?

A: We add back interest in this method (net loss plus depreciation plus interest) because we measure the resulting calculation against debt which includes principal and interest.

Q: Can you sum up what equals to $575,330 and $574,096?

A: The answer to the $575,330 amount is as follows, which is also explained in the written solution set:

Wages of $210,000 reported on Form 1040 at Line 7 and supported by Statement 3; interest income of $20,085 reported on Schedule B / Part I; distributions of $251,575 at Line 16 / Part III on Schedule K-1 (Form 1120S); loan repayment to McPherson by Sandover Contractors of $86,863 at Line 16 / Part III on Schedule K-1 (Form 1120S); and loans from Sandover Contractors to McPherson of $6,807 per the movement in the Due from Stockholders account on the Sandover Contractors’ balance sheet.

The answer to the $574,096 amount is as follows, which is also explained in the written solution set:

Wages of $210,000 reported on Form 1040 at Line 7 and supported by Statement 3; interest income of $20,085 reported on Schedule B / Part I; and Sandover Contractors’ profit of $344,011, which represents McPherson’s 100% share of company profit after the Section 179 deduction reported on Schedule E / Part II.

Q: Can you go over Poll Question #4 again? Is it ‘agree’ or ‘disagree’?

A: Poll Question 4 reads:

“All non-cash amounts reported on Douglas McPherson’s Schedule K-1 (Form 1120S) were taxable income while all cash amounts reported on the same Schedule K-1 (Form 1120S) were not taxable income.”

Poll 4 Answer: “Agree.” All cash amounts reported on Schedule K-1 (Form 1120S) – distributions of $251,575 and loan repayments of $86,863 – were not reported on Douglas McPherson’s personal income tax returns.

Q: Please revisit the difference between the non-recourse and recourse debt as on Slide 43. Typically, non- recourse means non-guaranteed.

A: This portion of the Schedule K-1 represents the accountant’s calculation of the pro-rata share of debt of an owner, and this section is used to determine the “basis” as well as “at risk loss limitations” of an individual owner.

If one is a general partner one is legally responsible for all of the debt of the partnership. And the only method of determining who personally guarantees debt is to ask the owner.   

Q: If McPherson had short term capital gains on Schedule D, would proceeds again be the only cash to him?

A: The proceeds would be cash to Douglas McPherson if the short-term capital gains were from the sale of personal assets. But if the short-term capital gains were from sale of assets by Sandover Contractors or Greater Pacific Realty Partners, the cash would flow to the company but McPherson would be obligated to report his pro-rata share of the short-term gain – non-cash to him – on his personal income tax returns.

Q: Should we not be subtracting investments purchased from the proceeds of the sale?

A: If an investment is purchased in a prior tax year and sold in the current tax year, then the cash impact is the proceeds received in the current tax year. However, if the investment is bought and sold within the same tax year, the cash impact is either the gain or loss in the current year.

Q: How do you know for sure that the $18,285 was a cash capital gain? Perhaps he took a seller note or something so the cash did not go into this pocket.

A: It would be an unusual transaction if one received a note instead of cash for the sale of an investment. If you feel that might be the case, the only way to be certain is to ask the owner or accountant.

Q: On the 2015 Form 1040 what are Qualified Dividends on line 9b? How are they different from Ordinary Dividends? Why aren’t they on Schedule B?

A: When you receive a dividend payment from an investment, it will fall into one of two categories for tax purposes -- qualified or ordinary. Qualified dividends are the more preferential of the two, as they have lower tax rates -- but not all dividends are eligible.
Qualified dividends should be listed in box 1b of the IRS Form 1099-DIV you receive, and they must meet two main criteria:

• Must be issued by a U.S. corporation, or by a foreign corporation that readily trades on a major U.S. exchange, or by a corporation incorporated in a U.S. possession.
• The shares must have been owned by you for more than 60 days of the "holding period", which is defined as the 121-day period that begins 60 days before the ex-dividend date, or the day in which the stock trades without the dividend priced in.

The difference between qualified and ordinary dividends is quite substantial when it comes time to pay taxes. As the name implies, ordinary dividends are taxed as ordinary income, while qualified dividends are taxed at a lower rate. Note, too, that the full amount of ordinary dividends of $875 was reported on Schedule B / Part II. Had some of those ordinary dividends been qualified, that amount would have been reported at Line 9b on Form 1040 as a sub-set of the $875 reported at Line 9a.

Q: When calculating cash available for debt service does DPAD have any relevance?

A: It has relevance if it reduces the amount of cash taxes paid in the year in question.

The Domestic Production Activities Deduction (DPAD) is applicable if it meets any of the following criteria:

• Construction of real property that was performed in the United States.
• Engineering or architectural services performed in the United States for construction of real property in the United States.
• Any lease, rental, license, sale, exchange, or other disposition of any of the following:
  • Qualifying production property manufactured, produced, grown or extracted in whole or in significant part in the United States.
  • Any qualified film produced, or
  • Electricity, natural gas, or potable water produced in the United States.

This deduction does not apply to income derived from the following sources:

• Activities not attributable to the actual conduct of a trade or business.
• The sale of food and beverages prepared at a retail establishment.
• Advertising and product-placement.
• The transmission or distribution of electricity, natural gas, or potable water
• The lease, rental, license sale, exchange, or other disposition of land
• Customer and technical support, telephone and other telecommunications services, online services (including Internet access services, online banking services, providing access to online electronic books, newspapers, and journals), and other similar services

A DPAD is generally 9% of the smaller of:

1. Qualified production activities income (QPAI), or
2. Adjusted gross income for an individual, estate, or trust (taxable income for all other taxpayers) figured without the DPAD.

However, a DPAD generally cannot be more than 50% of the Form W-2 wages paid to employees (including Form W-2 wages allocated to you on a Schedule K-1).

Q: Can you tell me where the loan of $6,807 is on the personal financial statements?

A: Douglas McPherson borrowed $6,807 from Sandover Contractors in 2015 as evidenced by the change in the Due from Stockholders account on the company balance sheet from $20,290 in 2014 to $27,097 in 2015. It is highly likely that this amount will not be repaid to the company and will simply be converted to a distribution in the near future.

Douglas McPherson does record the $27,097 obligation to Sandover Contractors in Note 5 on his personal financial statements.

Q: Why the ordinary business income and deduction are not included in the taxable revenue for McPherson?

A: On Slide 34 please note that Taxable Revenue for Douglas McPherson is summarized to include $344,011 of Sandover Contractor's company profit ($608,995 of Ordinary Business Income minus Section 179 Depreciation of $264,984).

Q: Why are the distributions not included in the cash flow to McPherson?

A: On Slide 34 in the presentation, please note that Cash Flows to McPherson are totaled to include $251,575 of Distributions from Sandover Contactors.

Q: With respect to information displayed about Schedule K-1 (Form 1120S) on Slide 19, can you explain the relevance of Tax Exempt Income, Nondeductible Expenses, and Distributions?

A: All of these amounts are used to determine an owner or partner's basis (or pro-rata share of accrual net worth) in a company. The resulting basis calculation is then used to determine whether or not an owner pays taxes on any distribution.

Tax exempt income adds to an owner's basis or net worth in a company, nondeductible expenses, which cannot be used to reduce taxable business income, reduce an owner's basis or net worth in a company, and distributions also reduce an owner’s net worth in a company.

Q: If a real estate holding company is a Subchapter S corporation, is any income or loss considered passive?

A: There are two kinds of passive activities.

• Trade or business activities in which the individual in question does not materially participate during the year.
• Rental activities, even the individual in question participates in them, unless he or she is a real estate professional

Income and losses arising from any rental activity are generally considered passive. One exception to this rule applies to real estate professionals: "If the taxpayer qualifies as a real estate professional, the taxpayer's rental real estate activity escapes the per se rule otherwise applicable to rental activity." In other words, the income and losses in this event are considered non-passive.

A taxpayer is considered a real estate professional if (a) more than one-half of the total personal services the taxpayer performs in trades or businesses are performed in real property trades or businesses in which the taxpayer materially participates and (2) the taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.

In our webcast example, Peter Keys is not a real estate professional. Therefore, his rental activities are considered passive.

Q: If Information Access Partners rents only to Information Access, Inc. and Peter Keyes is active in Information Access, Inc., shouldn’t income from Information Access Partners be re-classified as non-passive income, since the self- rental rule would apply?  If so, wouldn’t all losses remain passive?

A: In general, you are correct.

Taxpayers can generally offset rental income from one property by rental loss from another property, as passive loss is deductible to the extent of passive income. However, an exception to this simple rule occurs when property is rented to the taxpayer or to a business in which the taxpayer materially participates. In such a case, the rental real estate activity's treatment as passive or non-passive varies depending on whether it produces income or loss. In the case of a self-rental, income is treated as non-passive and loss is treated as passive.

In the example used in the webcast, the self-rental rule would seem to apply. However, the accountant may have reasons for the passive income classification, and it would be prudent to confer with the accountant as to the reason for the exception.

Q: For Question 6 in the exercise, why is line 17a (Post 1986 Depreciation Adjustment) on Schedule K not pro-rated on Schedules K-1 (Form 1065) for Peter Keys and Joseph Smith?

A: Rightfully the $1,975 recorded at Line 17a on Schedule K should be reported on a pro-rata basis at Line 17a on the Schedules K-1 (Form 1065) for Peter Keys and Joseph Smith.

The Post 1986 Depreciation Adjustment is used in the computations that determine whether Alternative Minimum Tax (AMT) applies. Since there was no ATM in this instance, the accountant may have left it blank.

Q: Do not loan repayments and loans to partners flow through form Schedule K to Schedule K-1 (Form 1065) the same way they do for a Subchapter S corporation?

A: There is no flow through for loans to partners and loan repayments for Form 1065 (partnerships) since loans from partners and loan repayments do not impact basis as they do in Form 1120S (Subchapter S Corporations). Therefore, for partnership this information is not captured on Schedule K and pro-rated on the Schedules K-1 (Form 1065).
 

Q: Would you consider medical and dental expenses as cash or non-cash?

A: We consider the medical and dental expenses reported on the personal income tax return to be cash expenses since they represent actual costs incurred by the taxpayer that not coveredby insurance payments or other forms of reimbursement.

Q: If Mr. McPherson elects not to take any distributions from his companies, is it generally acceptable to make adjustmentsto the total tax (federal income tax) reported in Line 63 of the Form 1040?

A: No. No adjustments should be made the total tax reported on the Form 1040 Line 63 in the absence of distributions. Distributions are tax free to thetaxpayer and do not impact an individual’s taxable income and, in turn, do not influence the total tax due in any way.

Q: On Slide 31 “Total partnership and S corporation income” is reported as $425,957 in Schedule E / Part II / Line32.  On Slide 32 “Rental real estate, royalties, partnerships, S corporations…” income is reported as $402,949 on the Form 1040 / Line 17. Why are these amountsdifferent?

A: $425,957 is combined net taxable income from McPherson’spartnership and Subchapter S Corporation reported on Schedule E / Part II / Line 32. Those earnings are then combined with his “Total rental real estate…” loss of $23,008 reported on Schedule E / Part I / Line 26. The $402,949 total is recorded in Part V / Line 41 and is further posted to Form 1040 / Line 17.

Q: Where did we get the $6,807 new loan proceeds described on Slide 34 in identifying Mr. McPherson’s cash flows?

A: The $6,807 comes from Sandover Contractors, Inc. accrual balance sheet and is not reported in Mr. McPherson’s personal income tax return. This amount is derived from the change in the current asset account “Due from Stockholders” by comparing the 2013 / 2014 balances. The $6,807 account balance change represents net new loans made by Sandover to Mr. McPherson.

Q: What happens to the Section 179 Deduction when there is more than one partner or owner?

A: The total Section 179 Deduction is shared among all the partners or shareholders on pro-rata basis, i.e., based on each person’s share of ownership in the business.

Q: Is the Section 179 Deduction a non-cash / non-taxable amount?

A: The Section 179 Deduction is indeed a non-cash depreciation expense associated with qualifying equipment acquired by the company. Only the company owner(s) may use the deduction to offset the non-cash ordinary business income allocated to them via their respective Schedule K-1s and reported on their Schedule E. The Section 179 Deduction serves to reduce the owner(s) taxable ordinary business income, since it directly reduces this source of income.

Q: Can you explain more about recourse and non-recourse financing as cited on a Partner’s Schedule K-1 / Part II / Line K?

A: In general terms, recourse financing means that an owner or guarantor, such as Mr. McPherson, is responsible for paying company debt obligations if the company cannot do so. Non-recourse financing means that the owner or guarantor has no obligation to pay company debt if the company cannot do so.

In this instance, recourse financing means that Mr. McPherson, as a general partner, is fully responsible for payment of all debt incurred by the partnershipif the company cannot pay.Non-recourse financing means that Mr. McPherson would not be liable for the debt if the company cannot pay. This would most likely occur if he were a limited partner.

Note that the IRS requires that only a partner’s pro-rata share of the partnership’s debt be reported on that individual’s Schedule K-1. That information is used to limit the amount an individual may claim as a loss if called on to actually pay the debt. Note also that this treatment in no way compromises or limits a general partner’s responsibility for all of a partnership’s debt.  

Q: Why is Mr. McPherson’s residential mortgage not included as part of his Living Expenses in calculating his cash flow available to service outside debt?

A: An individual’s residential mortgage principle and interest payment is considered to be a component of that person’s Personal Debt Service rather than as a Living Expenses or Cash Taxes Paid.

Q: Please explain the Form 1040 / Line 65 estimated tax paymentsof $80,000.

A: Estimated tax payments are required quarterly federal income tax payments made to the IRS on income not subject to withholding. Income subject to estimated quarterly payments is generally from all sources other than salary and wages.

The reasons for Mr. McPherson’s estimated payments totaling $80,000 in 2015 lie in the fact that none of the Schedule K-1 earnings for which he is responsible to pay taxes – such as ordinary business income from Sandover Contractors – are subject to withholding. He is, nevertheless, required to submit timely tax payments on the earnings and is, therefore,required to make estimated tax payments on the Sandover Contractors and Greater Pacific taxable business income.  

Q: In calculating Mr. McPherson’s Highly Liquid Personal Assets on Slide 60, why did we not include his checking account balance of $17,507?

A: Our assumption is that in a time of financial crisis at Sandover Contractors or Greater Pacific Realty Partners, cash flows from the affected company to Mr. McPherson would be reduced or eliminated well before an event of payment default by the company. In that scenario, Mr. McPherson would be forced to use his personal assets to pay personal living expenses, taxes, and service debt. Our belief is that he would use up the checking account balance very quickly for these purposes, and it would be completely unavailable as a cash resource to service company debt in a time of crisis.

Q: Slide 43 - Does the explanation means that tax loss is subject to maximum 40% on both recourse and non-recourse debt. But as a general partner, McPherson is liable for full recourse and non-recourse debt? Why will McPherson liable on non-recourse debt on both?

A: The explanation provided on Slide 43 indicates that Mr. McPherson’s ability to claim a tax loss on loans originated by the partnership is limited to 40% of the total loss incurred. This limitation is driven by his 40% pro-rata share of ownership in the partnership.

The recourse / non-recourse status is driven by IRS regulations that define the nature of these designations and whether Mr. McPherson is personally liable. Note that these designations are unrelated to the loan structure and the legal structure of the business that establish his responsibility to repay loans made to the partnership. General guidance is that, as a general partner, he is indeed fully liable to the lender for repayment of all loans made to the partnership.

Q: Slide 61 – How do we get $250,000 amount identified as “use of personal assets” for living expenses ($207,100) and personal debt obligation (16,092 + 115764 = 131856) which will total to 338,956?

A: The $250,000 cited on Slide 61 represents a portion of the $334,436 Mr. McPherson could potentially raise in disposing of his personally-owned liquid assets as depicted on Slide 60.

His purpose in liquidating those assets would be to supplement his reduced personal cash flow if Sandover Contractors experiences a financial crisis and could no longer contribute to Mr. McPherson’s personal cash flow as depicted on Slide 57. If that were to occur, his ongoing non-Sandover Contractors’ personal cash flows fall short of meeting his living expenses and personal debt service by approximately $250,000.  

Q: In Exercise #8 Solution - Why are “other expenses” reported under living expenses in the 1040 column of the solution shown as 0? We can have other expenses from schedule A on 1040 other than taxes and interest expenses. For ex. – Safe deposit box expenses, tax preparation fees, gifts etc. Will these expenses not be counted as other miscellaneous expenses on 1040?

A: No. Please note that the Job Expenses and Miscellaneous Deductions reported on Mr. McPherson’s Form 1040 / Schedule A must exceed 2% of his adjusted gross income as calculated on the Schedule A / Line 25. His total for this category fell well short of this threshold and are not considered deductible in 2015 and are accordingly not included in the 1040 column Living Expenses column.

These items are likely reported in the Cash Column as a component of the $20,000 “Other Expenses”.    

Q: In Exercise # 8 Solution – Regarding the calculation of “Taxes” presented in the 1040 column of the solution; FICA taxes of $7,347 & Medicare taxes of $3,045 are cash expenses as reported, but where are these expenses on 1040 as we have added them as “1040 column” expenses?

A: FICA & Medicare taxes appear in Statement 3 of the 1040 as referenced in the Exercise 8 Solution presentation. These items do not appear elsewhere in Mr. McPherson’s 1040 because they are not considered deductible expenses by the IRS.

Q: What is done on Line 12 and 13 on Schedule D?

A: Line 12 on Schedule D captures the individual owner’s pro rata share of gains or losses from investment activities of Subchapter S corporations, partnerships, estates, and trusts. Gains or losses from investment activities of a Subchapter S corporation or partnership are non-cash events to the recipient and are included in the taxable revenues reported by the recipient on his or her personal income tax returns. Gains or losses from estates and trusts, however, are generally cash events to the recipient and, again, are included in taxable revenues reported by the recipient on his or her personal income tax returns.

Line 13 on Schedule D generally represents cash capital gains and distributions from an investment fund, such as a Vanguard Fund, paid directly to the individual owner. This amount is taxable revenue to that specific owner and taxpayer.

These two line items are in contrast to Line 11 on Schedule D, which reports gains or losses from real property sales.

Q: Are you going to be covering cash contributions?

A: Consider cash contributions as a financing event totally unrelated to distributions and, therefore, not used as an offset to distributions. Contributions and distributions play very different roles in the financial life of the company and their owners and must, consequently, be classified differently in a personal cash flow statement. Distributions are included in calculations used in arriving at a personal cash flow surplus or deficit while contributions play no role in arriving at a personal cash flow surplus or deficit.

Q: Is the amount you deduct against your basis the only difference between passive and non-passive income?

A: An individual tax payer can only offset passive income with passive losses, to the extent they exist, to arrive at net taxable passive income. That is, the amount of passive loss that can be used to offset passive earnings cannot exceed passive earnings in any given year. In essence, the best a taxpayer can do is reduce passive earnings to zero dollars.

Note that IRS-driven guidance also directs that one cannot offset passive income with non-passive losses.  

In contrast, the amount of non-passive losses that can be used is not limited to the amount of non-passive income. As a result, when non-passive losses exceed non-passive income, thereby generating a reportable net loss, an owner’s basis, is in turn, reduced. This is a key contrast with the treatment of passive income / losses since one cannot report a net passive loss and is, therefore, prevented from reducing basis.

July 23, 2015

Q: How do capital loss carryovers effect cash flow analysis?

A: The cash flow impact of a capital loss must be fully accounted for during the year in which it occurs.  Recognize also that in doing so, it’s important to identify the full amount of the loss and consider its cash flow impact on the taxpayer during that year.  This suggestion takes on special importance since the IRS now imposes a limit on the amount of capital loss actually claimed in any tax year.  

The amount of the loss carried over into future years has no direct cash impact since no cash related to the original transaction changes hands during those subsequent years.  Do note that the carryover will reduce personal income taxes paid in future years (slightly), but attempting to make an adjustment to define recurring cash taxes paid seems not to be worth the effort.

Q: For Federal taxes, our bank usually use Line 63 on 1040 (Total Tax). Is there a reason why you prefer to add up the total tax paid + total tax owing? All the other taxes (state, local, real estate, etc.) are accounted for in the same manner. Thank you.

A: Line 63 (Total tax due) of $171,850 represents the total taxes paid on Mr. McPherson’s 2007 earnings. Please note that this amount was paid in the form of withholding ($40,905), estimated payments ($80,000), and a final payment ($50,945) with the 2007 tax return. When combined, these three separate sources of tax payments add up the total tax due on 2007 earnings displayed on Line 63 ($171,850).  

In calculating personal cash taxes paid by Mr. McPherson during 2007 as part of calculating his net personal cash flow, we included only 2007 Line 64 (Federal income tax withheld of $40,905) and Line 65 (2007 estimated tax payments of $80,000) because these cash tax payments were actually made in 2007. The incremental and final payment of taxes due for 2007 took place when Mr. McPherson paid Line 76 (Amount you owe of $50,945) when filing the tax return, probably very close to the April 15, 2008 filing deadline. The final payment of the “Amount you owe” should be treated as a 2008 cash taxes paid even though intended to fully satisfy his 2007 tax obligation.

Please check the Solution to Exercise Step #8 included with your post webcast materials to verify that we consistently applied this interpretation of cash taxes paid. The solution confirms that the April 15, 2007 payment of $79,434 to complete payment of taxes due in Mr. McPherson’s 2006 earnings was included in the compilation of cash taxes paid in 2007.

May 21, 2015

Q: How did we know to go to the Schedule K-1 for the $36,456 after looking at Form 4797?  

A: Since the information from Mr. McPherson’s Form 4797 was unclear about the ownership of property generating the long term capital gain, our first choice was to review the Schedules K-1 impacting the return. Our rationale relies on the fact that all capital gains taxable to Mr. McPherson are generated by property he owns or by property owned by a non-Subchapter C business in which he has an ownership interest. A review of the net long-term capital gain (loss) at Line 9a in Part III of his Greater Pacific Realty Partners Schedule K-1 (Form 1065) surfaced the entire amount. Had we not located the capital gain by researching the Schedules K-1, it would be fair to assume that property belonged to Mr. McPherson.   

Q: Where did you factor in the cash flow effect from capital gains when developing Mr. McPherson’s personal cash flow?  

A: We integrated the cash flow impact associated with Mr. McPherson’s long term gain from the sale of 500 shares of Aetna Life Assurance stock in building his Personal Cash Revenue analysis. In following the template in the webcast Exercise, we included the net gain of $4,241 in the spirit of conservatism rather than the actual sales proceeds of $18,285. Our logic in doing so was to acknowledge the sale as a non-recurring event based on the twelve year holding period.

Take advantage of guidance provided in your loan policy or underwriting practices to confirm which amount (sales proceeds of $18,285 or net long term gain of $4,241in this case) is appropriate to use in your analysis.   

Q: Should you take into consideration whether or not Mr. McPherson’s long term capital gain of $4,241 will be a recurring event?  

A: Absolutely, as we look ahead to the next period. Even so, it’s essential that we acknowledge the gain for the current period regardless of whether or not we consider it to be recurring. Be sure to reference your loan policy or underwriting practices to determine if the actual cash proceeds generated by the sale or the net capital gain should be included in the definition of cash flow. 

April 16, 2015

Q: Will you be discussing cash vs non-cash equity contributions?

A: Although we won’t directly address cash versus non-cash equity contributions during the webcast, the IRS recognizes “money and your adjusted basis in property contributed to the corporation or partnership” as factors driving an increase in the contributor’s basis in the business.

Q: How does one determine if a capital contribution was noncash?

A: Perhaps the most efficient way to distinguish a cash capital contribution from a non-cash capital contribution is to ask the borrower or the accountant. The impact on the shareholder or partner basis will be the same whether the contribution is made in cash or property.  

Q: Do guaranteed payments to partners flow to the personal tax return?

A: Yes. Guaranteed payments made to a partner and reported on that partner’s Schedule K-1 (Form 1065) for the year are indeed reported on the partner’s 1040 income tax return for that year. The payment is reported at Column J in Part II on Schedule E. The guaranteed payment is then consolidated with other income or loss from Partnerships and S Corporations in determining Total Income (Loss) on Line 41 on Schedule E. The net total amount determined in this way at Line 41 is then entered on the partner’s Form 1040 at Line 17.

Since guaranteed payments are not considered as wages or salaries, the payments will not be reported on a W-2. Nor will they be reported at Line 7 on Form 1040.

Q: On Schedule K-1 (Form 1065), there is a section that shows how much the partner contributed to the partnership. Is there anywhere on Schedule K-1 (Form 1120S) that shows the same thing? Or are contributions to a Subchapter S corporation not reported on Schedule K-1 (Form 1120S)?

A: An owner’s contributions to a Subchapter S corporation during the year are not reported on Schedule K-1 (Form 1120S).   

Q: Where can we identify the loss that offsets the $35,774 Net Rental Real Estate earnings realized by Information Access Partners?

A: The offsetting loss is found in Part I on Schedule E. This section reports the total taxable earnings (loss) from Mr. Keys’ three rental properties in the amount of a $121,454 loss at Line 22 in Part I. Note that all real estate income is identified as Passive Income by IRS guidelines and further that IRS guidelines also disallow Passive Losses that exceed Passive Income during the tax year.

Since Information Access Partners Passive Income from real estate operations was only $35,774, Mr. Keys was unable to claim the entire $121,454 loss realized on his personally owned rental properties for the year. He was, instead, allowed to use only $35,774 of the loss, which he reported at Line 25 in Part I on Schedule E and carried forward to Line 26 on the schedule. The net result is that the allowable loss of $35,774 from his personal real estate holdings exactly offset the taxable income of $35,774 from Information Access Partners.   

Q: Do the partnership liabilities have to be interest-bearing to be included in the calculation of a partner’s basis?

A: A partner’s basis is roughly defined as the partner’s accrual net worth in the partnership plus that partner’s pro-rata share of the partnership liabilities. All partnership debt, whether interest-bearing or not, is included in the calculation.  

Q: What was the answer to Poll #7?

A: Poll Question 7 is as follows:

Unlike the $581,746 of distributions reported on Peter Keys’ Schedule K-1 (Form 1120S), $55,467 of distributions reported on his Schedule K-1 (Form 1065) are considered wages and salary and reported at Line 7 on Peter Keys’ Form 1040.

The correct answer is “Disagree”. Distributions reported on either a Schedule K-1 (Form 1120S) from a Subchapter S corporation or a Schedule K-1 (Form 1065) from a partnerships or limited liability company are not considered taxable revenue to an owner or partner. They are never included with wages and salaries reported at Line 7 on Form 1040.

Q: Shouldn't Schedule M-2 in Form 1120S for a Subchapter S corporation reflect the total of the Schedules K-1 (Form 1120S)?

A: In general use, the net sum of the Schedule M-2 entries does not match the total taxable impact of entries made to the Schedule K-1 and rolled up to the Schedule K.

Schedule M-2 is intended to identify the net effect of all business activities on the total shareholders’ basis regardless of the tax impact. Accordingly, the 2009 Information Access, Inc. Schedule M-2 integrates several items, e.g., ordinary business income, interest income, and charitable contributions that have a direct impact on both the shareholders’ basis and tax liability. Schedule M-2 in this case also pulls in an item – non-deductible expenses of $71,908 that are summed with $2,872 of contribution expense – that has no taxable impact but does serve to reduce shareholder basis. The net result is a $37,796 increase to total shareholder basis for the year.

Schedule K is intended to identify net taxable income or loss for all shareholders for the year. The schedule presents this net figure at Line 18 – Income/Loss Reconciliation Section – in the amount of $109,704.

If one uses Schedule K data in a way that goes beyond the document’s intent, the entries can be made to match the results reported on Schedule M-2. In this case, one can accomplish this by simply subtracting the non-deductible expenses of $71,908 from Line 18 net taxable income of $109,704. The result is $37,796, which is the amount reported at Line 6 on Schedule M-2.

Q: Please help me understand when a “Fund” will generate a Schedule K-1. For example, we have several clients that show Morgan Stanley Funds on Schedule E. Should we be collecting Schedules K-1 for these types of entries?

A: Fund amounts reported on Schedule E may represent an investor’s share in a fund structured as a limited partnership, particularly for exchange traded funds. The investor and taxpayer is invariably a limited partner, and, as a limited partner, reports his or her share of partnership income in the fund as passive income according to information in the Schedule K-1. If the reported amount is at all material, you certainly may wish to request the underlying Schedule K-1.

April 08 2015

Q: Regarding Mr. McPherson’s Schedule B, why is Sandover Contractors, Inc.’s interest income to Mr. McPherson included as part of his cash income for the year?

A: The $20,085 interest income reported on Schedule B from Sandover Contractors, Inc. was, in fact, cash income to McPherson. This amount represents interest paid to Mr. McPherson on a loan he has made to the company. The loan is an interest-bearing instrument he owns and generates both taxable income and cash flow to him.

Only the $4,567 of Schedule K-1 interest income earned by Greater Pacific Realty Partners was non-cash to McPherson; i.e., the associated cash went to Greater Pacific Realty Partners as owner of the instrument, making the transaction a non-cash event to McPherson.

Q: If a partnership is 100% owned by an individual, can we include the business income as part of the global cash if the partnership did not make a cash distribution to the individual owner when we compute global cash flow?

A: The business income reported to a 100% owner for taxation would still be a non-cash event to the owner or partner in computing personal cash flow. The standard definition of global cash flow adds business net profit after adjusting for interest expense, depreciation, distributions, and loans to owners to the personal cash flow surplus provided by the individual. In the absence of distributions or loans, the global cash flow definition would adjust business net profit upward by removing only business interest expense and depreciation. That net amount would then be added to surplus personal cash flow to determine global cash flow available to service the company’s interest-bearing debt.

Q: On slide 34, it breaks down incoming cash flows covered until that point of time in the presentation, however, it does not include the $1,001 CD interest nor the $875 dividends from stock. Is this a mistake or are those entries not considered cash flow?

A: Our intent on Slide 34 (Step 6 Cash Flows and Taxable Revenue Summation) is to depict only the cash flows and taxable revenue Mr. McPherson derived from Sandover Contractors, Inc. during 2007. The two items you cited were not sourced by Sandover. Our purpose in this deliberate approach is to take the first step in establishing just how important a financially healthy Sandover Contractors is to Mr. McPherson.

Please note that we did include the interest payment and dividends you referenced in the comprehensive statement of Mr. McPherson’s Personal Cash Revenue from all sources depicted in Slide 45.  

I may very well have referenced the information on Slide 34 as all cash flows and taxable revenue to Mr. McPherson discussed to that point in the webcast. I apologize for the confusion my comment created for you and possibly for other webcast participants. Thanks for bringing this to our attention; we'll make every effort to avoid letting it happen again.

January 29, 2015

Q: Could you explain “self-employment earnings (loss)” reported at Line 14C for gross non-farm income?

A: In very general terms, partnership earnings are considered self-employment earnings as if each individual partner were an independent operator. As a result, each individual partner must report his or her pro-rata share of partnership earnings as self-employment earnings, which is captured at Line 14 on Schedule K-1 (Form 1065). Line 14A captures generic partnership earnings. Line 14B applies to earnings from farming or fishing. Line 14C is a variation of Line 14A – a “nonfarm optional method” in IRS terminology – which allows a partner to use this option if earnings fall below a very low minimum. Otherwise, self-employment earnings for the partner would be reported at Line 14A.

Note, however, that there are very explicit exceptions to the general concept that partnership earnings are self-employment earnings. With respect to Peter Keys and Information Access Partners, his pro-rata share of partnership earnings are not consider self-employment earnings because IRS regulations exclude rental revenue from the definition of self-employment earnings. All of Information Access Partners’ revenue, in turn, is rental revenue.

In addition to rental revenue, partnership income from dividends and royalties is not considered self-employment revenue or income.

Partners receiving and reporting self-employment earnings must pay a self-employment tax, which is a combination of 12.4% for Social Security and 2.9% for Medicare. The Social Security portion of the self-employment tax applies only to the first $118,500 of self-employment earnings for the 2015 tax year. There is no limit to the amount that is taxable under the 2.9% Medicare portion of the self-employment tax.

A partner reporting self-employment earnings uses Schedule SE (Form 1040) to determine the amount of tax due and payable. A partner can deduct the employer-equivalent portion of his or her self-employment tax in computing adjusted gross income on Form 1040. Wage earners, on the other hand, cannot deduct Social Security and Medicare taxes in computing adjusted gross income on their Form 1040.

January 22, 2015
 
Q: Is the Section 179 Deduction always depreciation?

A: The Section 179 Deduction is always a deduction against taxable income for the owner to whom it is conveyed. That is, it is used to offset taxable business income passed to the owner by his or her company or partnership, who is responsible for payment of income taxes on a company’s or partnership’s taxable business income.

Although the deduction is driven by the company’s acquisition of “Section 179 eligible” equipment, it is never recorded as depreciation expense for the company. IRS rules simply forbid it from being used as a company depreciation expense.

Q: Is the Section 179 Deduction (depreciation on equipment purchased by the company) actual cash flow for the individual owner?

A: No, there is no cash to the owner. The Section 179 Deduction reduces taxable income reported on the owner's Schedule E and carried to Line 17 on his or her Form 1040, but there is no cash that flows to him or her by virtue of the deduction itself.

Q: What are the tax implications of recourse versus non-recourse obligations reported on the Schedule K-1 (Form 1065)?

A: The amount of recourse obligations reported on Schedule K-1 (Form1065) represents a cap to the amount of loss the partner can ultimately claim to offset other sources of taxable income in the event the partnership fails to meet these debt obligations, thereby forcing the partner to use personal funds to satisfy the debt obligations.
 
It is important to note that these designations in no way impact the general partner’s responsibility for the entire amount of the partnership’s debt. The lender is not prevented from demanding that any one of the partner’s satisfy the entire debt. These categories simply limit the partner’s loss to his or her pro rata share of the partnership debt.

Q: On Slide #57 – “In Absence of Company Cash Flows” – where did the negative $345,245 adjustment to Mr. McPherson’s 2007 cash flow come from?  I come up with a negative $419,583 from the Schedules K-1, i.e. $88,145+ $251,575 + $86,863.

A: Our intent on this slide is to estimate the likely reduction in the amount of cash flow from Sandover Contractors, Inc. to Mr. McPherson if the company experiences a financial crisis and the cash flow to Mr. McPherson from the company is disrupted.
 
There are three cash flows from the company to Mr. McPherson that would likely disappear in a company financial and cash flow crisis:

• Distributions from the company of $251,575;
• A loan repayment from the company of $86,863; and
• A loan from the company of $6,807.

The sum of these three cash flows is $345,245.

In your computations, it appears you included the $88,145 distribution from Greater Pacific Realty Partners. That would be appropriate if the partnership’s sole source of revenue were rental payments from Sandover Contractors, Inc., but there is nothing in the case materials to suggest such a relationship.

Q: I see a lot of closely held corporate entities in which an owner buys property in the owner's name and then leases it back to the business. Is this generally done for tax purposes? Or balance sheet management? Or both?

A: Company owners acquire assets that are then leased to the company for a number of reasons and you seem to be right on track.
 
The company may indeed realize financial advantages by leasing the property versus owning that same property, one of which might be a tax advantages in that higher deductions apply to lease payments than can be claimed as depreciation expense from owned assets. In addition the lease payments represent a cash flow opportunity for the owner.

Further, the leasing option for the company may be a cash conservation measure that allows it to use cash resources to invest in other growth opportunities or to invest in other higher return options.

In addition, your reference to managing the company balance sheet may also be on track.

Bottom line is that there is certainly value in exploring the reasons with the owner to determine the rationale for such acquisition and financing decisions.     

Q: Why are the Sandover Contractors, Inc. and Greater Pacific Realty Partners Schedule K-1 issued to Mr. McPherson marked as final Schedule K-1?

A: This designation is a mistake. Both businesses are ongoing entities and the Schedules K-1 should not have been identified in this way. A “Final K-1” designation means that the partnership or corporation is going out of business. Not so in this case.

November 20, 2014

Q: What does Line 5 show on Schedule A?

A: Line 5 on Schedule A shows that McPherson paid $77,705 in state and local income taxes. This could be a combination of state withholding taxes and estimated tax payments to meet state income tax obligations on both his Subchapter S corporation and partnership. Statement 4 in McPherson’s personal income tax returns provides the supporting documentation for the $77,705 entry.

Note, too, that there are no readily identifiable assets with we can associate this entry on Schedule A.  

Q: If the amounts reported at Line 16D and 16E on the Schedule K-1 from Sandover Contractors, Inc. are not taxable to McPherson as the owner, have they been taxed at the corporate level?

A: Line 16D on Schedule K-1 (Form 1120S) Line identifies distributions of $251,575 that Sandover Contractors, Inc. paid to Douglas McPherson during 2007, which are NOT taxed at the corporate level or at the personal level under IRS guidelines. Line 16E reports $86,863 of loan repayments from Sandover Contractors, Inc. to Douglas McPherson, which are not taxable income to McPherson nor are they a tax deductible item to the company.

Q: On Schedule E, why are some entities’ income taxable to the owner or partner reported as Passive and some are reported as Nonpassive?

A: The taxpayer, in this case Mr. McPherson, must be fully engaged in managing the business to qualify the earnings for reporting as Nonpassive income. For this reason the earnings of Sandover Contractors, Inc. are considered to be Nonpassive since he is an active manager of the company. If the owner is a silent investor only and is not active in managing the business, the status would be Passive. The IRS provides strict guidelines for determining Passive and Nonpassive status.

An additional important consideration lies in the fact that IRS guidelines require that Passive losses cannot exceed Passive earnings just as Nonpassive losses cannot exceed Nonpassive earnings for the year. This guidance is very important in the event multiple business entities or similar personal business activity (as we saw with Mr. McPherson) are being reported. 

October 22, 2014

Q: Is it possible to see pass-through taxes (state and local) on Schedule A of the personal tax returns?

A: To the extent that a company pays state and local taxes directly, those taxes are included in “ordinary business income” on the business income tax returns, which is passed through to owners and partners. If a partnership or company is domiciled in a state and city that does not levy personal income taxes, there is no pass through, i.e., the partners and owners are not obligated to pay state and local income tax on their company’s taxable income streams. Obviously if such income taxes are levied by state and/or local authorities, partners and owners are responsible for paying income taxes on all taxable streams of partnership or company income.

Form 1040 Schedule A does captures the amount of individual state and local taxes paid by taxpayer, including any estimated state taxes and local taxes, if applicable, on partnership or company income.

Q: What is the purpose of guaranteed payment?

A: The purpose of guaranteed payments is to assure selected partners a minimum and guaranteed amount of income from the partnership. The terms and conditions of such guaranteed payments would be recorded in the Partnership Agreement. The partnership does not withhold taxes from guaranteed payments, but, rather, the partners receiving the guaranteed payments must make all necessary tax payments, e.g., personal income tax withholdings, FICA, and Medicare withholdings.

In the case of guaranteed payments, all tax withholding obligations pass from the partnership to the partner.

Q: So as you take distributions does the “at risk/basis” go down accordingly?

A: Yes, anything such as distributions that decreases a partner's capital in the partnership or in a Subchapter S Corporation decreases "basis" and, therefore, "at risk” loss limitations.

Q: Can we think of Guaranteed Payments similar to W/2 income?

A: You can think of them as somewhat similar to W/2 income, except that the partner is responsible for paying all taxes on guaranteed payments, e.g., income tax, FICA, Medicare, etc. That obligation passes from the partnership to partner.

Q: When considering business only cash flow is it appropriate to add back guaranteed payments to partners if the monies are not required in satisfying personal debt payments?

A: No, guaranteed payments are cash out the door and are likely spent immediately, similar to salary dollars. They should be treated like any other business expense.

July 31, 2014

Q: What was the answer to Poll Question #3?

A: Poll Question #3: “The sum of amounts reported at Lines 1, 4, 12a, 16c, and 16d on Information Access Inc. Schedules K-1 for Peter Keys and Joe Smith was equal to the amount reported at each of those lines on Schedule K in the company’s Form 1120S business tax return. Agree or Disagree?”

The correct answer is to “Agree” with this statement. IRS guidance is that the sum of all pro-rata share-driven Schedule K-1s issued must equal the total amount reported on the corresponding lines of Schedule K.

Q: Loan repayments reported on a Schedule K-1 (Form 1120S) for a Subchapter S corporation are on stockholder loans and are actually made in cash. Correct?

A: Yes, the loan repayments reported on Line 16 E are stockholder loans per IRS instructions limiting this line item to "repayment of loans from shareholders”. Invariably, such repayment is made in cash. However, there could be a business decision to write-off the debt due or accept a repayment in kind. If a write-off, the company would have to recognize a gain for tax purposes and, presumably, the shareholder could claim a loss on his or her personal income tax return. But, unless there is any reason for suspicion, assume a cash repayment.

Q: I don't really understand why distributions are not taxable since they are reported AFTER net income and are not taxed at the corporate/partnership level. Is this just because of IRS regulations or for some other reason?

A: You are correct in assuming that IRS regulations drive tax-free treatment of distributions not exceeding the shareholder or partner basis in the company. The underlying rationale for distributions is to serve as a mechanism to make cash available to owners with which to pay taxes on the earnings of a non-Subchapter C business without creating further tax consequences.

Q: If the Final Box on a 1065 is checked, is it the final (last) form filed for this borrower?  Either dissolved or out of the partnership?

A: If it's checked, it means the partnership has been liquidated/terminated in the year in question and the K-1 submitted by the partnership is the final transmission of information from the partnership to the partner.

If the Amended K-1 box is checked, it indicates that some problem with the original Form 1065 and associated Schedules K-1 occurred, e.g., inaccuracies, omissions, etc., and has been resolved and corrected via the Amended K-1. The partnership continues.

July 24, 2014

Q: So why go through the personal cash flow if liquid assets are all that really matters?

A: It's a standard industry procedure to construct a Personal Cash Flow (PCF) statement as part of a responsible credit analysis. When we adjust the PCF to eliminate cash flowing from the borrowing business entity, we gain a meaningful perspective on the strength of the guarantor’s cash flow. This step will frequently demonstrate that the guarantor’s personal cash flow is highly dependent on the company and that the guarantor’s financial strength would be negatively impacted if that source of cash goes away.

By then identifying cash that can be generated in no more than five business days by liquidating personally-owned assets, we gain an even clearer perspective on the overall strength of the guarantor.

It’s this combination of procedures that gives our credit analysis credibility that leads to sounder credit decisions.  

Q: What is a good ballpark figure for living expenses if we're not familiar with the individual's lifestyle?

A: Generally, a guarantor will provide rough estimates of his or her living expenses, which we always accept with a healthy dose of skepticism since the expense estimates are never supported with underlying documentation. In this instance, Mr. McPherson provided his estimate of personal living expenses at $96,000 and total personal expense of $668,822. Even so, we are compelled to rely heavily on our ability to “know the customer” and understand his or her lifestyle. Our familiarity with a guarantor’s community involvement, social status, and personal habits are important building blocks in creating a sensible, even if not totally reliable, estimate of personal living expenses.

Note, too, that we can identify additional personal expenses, such as alimony payments, medical and dental expenses, and taxes paid from information provided on Schedule A, for example, in a guarantor’s personal income tax returns.  

In addition, we can take some degree of guidance from the fact that the average U.S. savings rate in recent years has been around 4% to 5% of disposable personal income (DPI). DPI is defined as “the amount of money that households have available for spending and saving after income taxes have been accounted for”. Using the complement to this statistic, individuals are spending roughly 95% of DPI on housing, personal living expenses, debt service, taxes other than income tax, and medical / other expenses.

Regardless of whether a guarantor provides information about his or her personal living expenses or we’re compelled to estimate those expenses, the resulting estimate is very rough and highly uncertain in the best of circumstances. That, in turn, strongly suggests that the bottom line numbers in a personal cash flow statement, i.e., the personal cash flow surplus or deficit, may be highly inaccurate, which throws further doubt on the use and value of a personal cash flow statement as a measure of guarantor support for company debt service in a crisis.

Q: My question is regarding federal and state taxes for individuals.
 
We normally don’t include these, as we are trying to estimate cash flow available to the individual guarantor for debt service obligations (for loan qualification purposes), prior to taxes, interest, depreciation, amortization. I have worked for several institutions, and this line item was treated differently in each institution. I’ve also consulted with some of my senior underwriters, and they also indicated that normally, for loan qualification purposes, taxes were not included as part of cash flow, as they are not reliable figures (meaning, they could be manipulated), also, they could include taxes paid on partnership income, while we don’t have a complete picture of partnership income (we could be missing K-1’s, etc). Instead, we would normally include a living expense, anywhere from $40K to $100K, depending on our knowledge of the person’s lifestyle and income, which we thought would cover taxes as well.
 
What are your thoughts on this? What is industry standard on taxes? Do you know if other financial institutions (commercial lending) are including taxes as part of cash flow for loan qualification purposes?

A: I would invariably include federal and state taxes in any estimate of a guarantor's cash flow available to service interest-bearing debt obligations. The tax authorities are voracious about collecting taxes. To ignore this expense may provide some very misleading estimates of debt service ability.

If you have a guarantor's most current personal income tax returns, you should have enough information to closely identify the amount of personal tax payments for that year. All income tax withholdings will be listed, along with all estimated federal income tax payments for year. Those estimated payments may apply to an S corp for which you have the Schedule K-1 or it may apply to a range of partnerships or other S Corps for which you have no Schedules K-1. But the amount listed for federal income tax payments applies to estimated payments made by the guarantor for all companies in which he or she has an ownership share and for which he or she is personally liable for income tax payments on taxable earnings from those companies.

In addition, information in Schedule A, along with clarifying statements, should provide solid information about state income tax payments, which a taxpayer will certainly record since those expense drive down his or her federal income tax obligation.

In the event you do not have current personal income taxes for the guarantor, e.g. they are on extension, you can use the most current returns you have and compute an effective income tax rate by dividing adjusted gross income by the sum of a) all federal income tax withholdings and estimated payments and b) all state income tax payments. Then apply that ratio to the guarantor's estimate of most recent AGI. The guarantor or the accountant should have that information - in fact, should have all the information about income tax payments - since a return put on extension is subject to rather severe penalties if the estimate of the personal income tax obligation is off by more than 10% (as I recall) when the final return is filed.

My two cents worth is to include federal and state income taxes - even if they are tough to estimate because of missing information. In my experience, they are generally easier to identify or estimate than personal living expense or personal debt service obligations.

May 22, 2014

Q: Did you say that the amounts recorded on Schedule K-1 (Form 1120S) at Lines 16D and 16E are cash flows to Mr. McPherson?

A: Both the $251,575 distribution reported at Line 16 D and the $86,683 loan repayment reported at Line 16 E are cash payments to Mr. McPherson. The designations A, B, C, D, and E are explained on the second page of the Schedule K-1 (Form 1120S), which we did not include in the interest of reducing paper. Line items coded 16 A refer to tax-exempt interest income; those coded 16 B represent other tax exempt revenue generated by the reporting company; and items coded 16 C refer to nondeductible expenses.

Q: Can you please elaborate on items affecting shareholder basis on the Schedule K-1 (Form 1120S) again? Thank you.

A: In general terms, a taxpayer's basis is his or her accrual net worth in the company plus any loans made by the owner to the company. The shareholder basis (accrual net worth) increases by the owner's pro-rata share of profit, increases by an owner's capital contribution, and decreases by the amounts of distributions or loan repayments from the company to the owner.

Line 16 on Schedule K-1 (Form 1120S) records five possible events that affect shareholder basis. Tax-exempt interest income increases a shareholder’s accrual profit, net worth, and, therefore, shareholder basis. Other tax-exempt revenue has the same impact. Non-deductible expenses, on the other hand, decrease a shareholder’s accrual profit, net worth, and, therefore, shareholder basis. Distributions decrease a shareholder’s net worth and, therefore, his or her shareholder basis. Finally, when the company repays loans made by the shareholder to the company, the reduction in shareholder loans outstanding decreases shareholder basis.

Q: Can you please elaborate on the excess cash flow that is not taxable?

A: Distributions and shareholder loan repayments are not taxable (unless they are so large that they drive shareholder basis into negative territory), but, rather, provide the shareholder with cash necessary to pay federal and state income taxes on a company’s taxable income. The income tax obligation is passed from the company to the owners for Subchapter S corporations, partnerships, limited liability companies, and sole proprietorships.

If the amount of cash paid out in this manner exceeds the actual income taxes due and payable by the owner on his or her pro-rata share of a company’s taxable income, the excess payout is simply compensation to the owner. Any compensation paid to the owner in this way is untaxed, since distributions, loan repayments, or loans from a company to owners are not reported as taxable revenue on the owner’s personal income tax returns.  

Q: Please provide the answer and explanation to Poll Question 5 again.

A: Poll Question 5 states “Since Douglas McPherson’s share of taxable partnership revenue in 2007 was $122,969, the $88,145 of distributions from the partnership forced McPherson to use personal cash resources to pay income tax on his share of partnership profit.”

We disagree with this statement.

The $122,969 in net taxable earnings “passed through” to Mr. McPherson by Greater Pacific Realty Partners as reported on Schedule K-1 (Form 1065) is subject to both federal and California state income tax. The maximum combined income tax rate is 44.9% – 35.00% and 9.30% for federal and California, respectively – and results in a combined estimated maximum tax due of $54,475, i.e., ($122,969) x (0.443) = $54,475.

The $88,145 of distributions to Mr. McPherson during this tax year was well in excess of the estimated taxes due. Therefore, he was NOT forced to use personal cash resources to pay taxes on his share of partnership profit.   

Q: Where is the $2,750 in Notes Payable and Advances from Sandover Contractors found?

A: This amount represents investment interest expense paid by Mr. McPherson on his margin account or on other loans secured by investment assets. The amount appears at Line 14 on his Schedule A and then again in Statement 7 of his personal income tax return.

Q: Can you review the Section 179 deduction again? Should it ever be treated as an expense for the business?

A: The amount of a Section 179 deduction is determined by the reporting company’s acquisition of qualified fixed assets during the tax year. The deduction is used exclusively by the owners to reduce their share of the company’s taxable business income. It is never included as a business expense by the company. The IRS regulations specifically prohibit the reporting company from including the deduction in its array of allowable business expenses.

Therefore, the amount of the Section 179 deduction cannot be used to reduce the company’s ordinary business income. It may only be used by the owners to reduce their pro-rata share of taxable ordinary business income “passed through” to them by the company.

Q: On 2007 Cash Taxes Paid, where did the prior year amount owned of $79,434 come from?

A: The amount was provided as part of Step 8 in the exercise. We include it in 2007 Cash Taxes Paid since it represents the net amount due on Mr. McPherson’s 2006 tax return filed during 2007. Because Mr. McPherson’s 2006 withholding and estimated tax payments fell short of his actual 2006 tax liability by $79,434, he paid this amount when he filed his 2006 personal income tax returns between January 1 and April 15, 2007.

Q: I have a question from the class that has come up with one of our customers. This is in reference to long term Capital Gains from the sale of stock. In the class example, the sales price was $18,285 and the cost basis $14,044. Only the difference of $4,241 was considered cash flow. The spreading software we use considers the full $18,285 as cash flow. I’m wondering could an argument be made to use the $18,285 vs. $4,241 as cash flow since the stock was held long term and the customer has received the full benefit?
 
For short-term capital gains, the software does consider the difference between sales price and cost basis as cash flow.

A: If the stock is purchased in a prior period and sold in the current period, I think it makes very good sense to consider the full sales price as a cash inflow in the current period. In other words, accept the method used by the software.

In the webcast, we illustrated the more conventional means of considering gains or losses on sale of assets, but I think the better approach is to consider the sales price as a cash inflow in the present period so long as the asset was purchased and paid for in a prior period. If the purchase and sale took place in the present period, then the difference between the two amounts would be the cash flow for the present period.

April 23, 2014

Q: Do the owners or partners pay income taxes on distributions from a partnership?

A: No. Partners in a partnership do NOT pay income taxes on distributions. They are tax-free to the partner, unless they exceed the partner's basis or, in effect, their pro-rata share of net worth in the partnership. However, if partners receive guaranteed payments, they do pay income taxes on those payments.  

Q: Is the total cash to Peter Keys $813,746 since there was loan repayment? Earlier you indicated that a mistake may have been made on the Schedule L since loans from shareholders decreased by $232,000. Where did these funds come from? Is it cash to Peter Keys?

A: The 2009 cash flows to Peter and Jennifer Keys from Information Access, Inc. was $1,051,266 on a gross basis or $981,195 on a net basis, as follows:

• Gross salaries of $220,000 or salaries net of all withholdings of $149,929
• Interest income $17,301
• Distributions $581,965
• Debt repayment $232,000, which is definitely cash to Peter Keys

The sum of these four amounts is $1,051,266 on a gross basis or $981,195 on a net basis.

With respect to the $232,000 loan repayment from the company to Peter Keys, we cannot determine the cash source without constructing and examining a 2009 Uniform Credit Analysis (UCA) cash flow statement for Information Access, Inc. There are two likely candidates. The company’s cash flow from business operations may have been sufficient to cover all operating expenses, cover interest-bearing debt service, pay for fixed asset acquisitions and, finally, repay $232,000 of debt to Peter Keys. Or, as an alternative, the company may have borrowed from outside third parties in order to repay the $232,000.

We can only identify the actual source of cash for the $232,000 debt repayment by reference to a UCA cash flow statement for 2009.

The 2009 cash flows to Peter and Jennifer Keys from Information Access Partners was $180,467, as follows:

• Distributions of $55,467
• Loan from the partnership of $125,000

The sum of these two amounts is $180,467.

Q: To clarify, are “guaranteed payments” the sole item from Schedule K-1 that would be considered in order to determine the individual partner's debt service ability. Or could you include distributions as well?

A: On a Schedule K-1 (Form 1065), the cash amounts to a partner are distributions and guaranteed payments (if any). On a Schedule K-1 (Form 1120S), the cash amounts to a shareholder are distributions and loan repayments (if any).

Apart from cash amounts reported on Form 1040, such as salaries and interest income, it is also necessary to check for a) any loans to partners or shareholders as well as any loan repayments for loans previously made by the partner or shareholders. Schedule K-1 (Form 1120S) should properly capture and report loan repayments to owners, but Schedule K-1 (Form 1065) does not record loan repayments. In this instance, we need to examine the partnership’s balance sheet to identify loan repayments to partners.

In either case, we need to examine the partnership’s and company’s balance sheet to identify loans to partners or shareholders.

April 10, 2014

Q: Why wasn't the gain on the sale of Rental Real Estate from Form 4797 (Sales of Business Property) reflected on Schedule D at Line 12?

A: The capital gain realized by Greater Pacific Realty Partners and reported on the Schedule K-1 in the amount of $36,456 was first posted to Mr. McPherson’s Form 4797 in preparing his tax return.  IRS regulations require that any amounts reported on a partner’s Schedule K-1 at Line 9 be reported on Part I in Form 4797.  

Amounts reported on Part I in Form 4797 are then carried to Line 11 on Schedule D and included in the final calculation of net long-term capital gains of $40,697.  Net long-term capital gains of $40,697 were then posted to Line 13 on Mr. McPherson’s Form 1040 for inclusion in his total income reported at Line 22.

Q: Can you please clarify why you are using net cash gain for long-term capital gains related to Mr. McPherson’s sale of Aetna stock as opposed to the sale price of $18,285.  Our thought process was the cost happened in a prior year, i.e., in 1995.

A: Certainly you can use the full $18,285 cash proceeds realized in 2007 since the original purchase happened 12 years earlier.  The full sales price represents cash flow generated in 2007 that was available to Mr. McPherson to support his personal living expenses and debt service.   

We used the cash gain to follow the conventional approach, even if that approach understates the actual amount of cash flow in 2007.  As we pointed out on Slide 42, our own preference is to use the actual cash amount of the sale, which, in this instance, was $18,285.  However, going forward, we would exclude one-time gains or losses from cash flow calculations.    

Q: If you are taking distributions as cash, how do you know they will be sustainable?

A: We don't know if they are sustainable.  We do know, however, that distributions were indeed a considerable source of personal cash flow in 2007.  

Whether they are sustainable going forward requires considerable assessment of Sandover Contractors’ ability to provide distributions in that amount.  We can assume that Mr. McPherson’s cash requirements will not diminish or abate, since nothing is more difficult to downsize or alter than a lifestyle.  And, as we saw, Mr. McPherson’s personal cash flow surplus was quite marginal, which included both distributions and loan repayments from Sandover Contractors and Greater Pacific Realty Partners.  He cannot meet his array of living expenses, taxes, and personal debt obligations without relying heavily on distributions from his two companies.

The conservative approach in underwriting Mr. McPherson as a guarantor is to assume that the distributions are not sustainable as we did in re-defining his personal cash flow in the event Sandover Contractors experiences some form of financial crisis.  

Q: What was the answer to poll question 5?

A: Poll question 5 was as follows:

“Since Douglas McPherson’s share of taxable partnership revenue in 2007 was $122,969, the $88,145 of distributions from the partnership forced McPherson to use personal cash resources to pay income tax on his share of partnership profit.”

The answer is Disagree.

At a maximum personal income tax rate of 44.3% (California state and federal combined), he would need $54,475 to pay income taxes on the partnership taxable income. Yet he received $88,145 in distributions from the partnership. Obviously there is no need for him to dip into personal cash resources in paying taxes on the partnership earnings.

January 30, 2014

Q: On a Schedule K-1 (Form 1065) is there any instance when the distribution amount at Box L in Part II would not match the distribution amount listed at Line 19 in Part III?

A: In theory and in practice the distributions should be the same amounts. It is conceivable, but highly unlikely, that the amount reported at Box L reported on a GAAP basis might differ from the amount reported at Line 19 reported on a tax basis. If any difference ever exists, ask the taxpayer or accountant for an explanation.

Q: Is it always charitable contributions on Other Deductions of a Schedule K-1 (1102S) or could they also be a cash contribution reported there?

A: Other Deductions at Line 12 reflects the taxpayer's pro-rata share of deductible contributions made by the company. Those are different from cash contributions from the taxpayer/owner to the company which are not captured on Schedule K and Schedule K-1 for a Subchapter S corporation.

Q: With Travel and Entertainment being a 50% deduction on business income tax returns, what is to stop a company from classifying those expenses as "employee benefits" to get a full deduction as an expense on their general ledger?

A: A business could incorrectly classify such expense but, since the Enron scandal, accountants must now accept greater liability for false income tax returns that they sign; hence they are quite concerned to get it right on expenses.  Even so, the integrity of management is the critical consideration that determines the validity of business income tax returns and company financial statements.  If you doubt management’s integrity, be very cautious about business income tax returns and the underlying accrual financial statements.

Q: Does basis include retained earnings as a portion of the accrual net worth?

A: Yes. A taxpayer's basis includes his or her capital contributions plus his or her pro-rate share of retained earnings less any distributions paid to the taxpayer/owner.

Q: Can you please explain the difference between a real estate company that would be considered a holding company and, therefore,report passive income and losses, versus a real estate company that would report non-passive income and losses?

A: In general, a real estate company that provides financing to acquire and own other real estate companies with rental real estate properties would report passive income from its investment since the holding company would not participate in the active management of the underlying real estate properties.  It simply invests in other businesses that own and manage the income producing properties.  However, if a real estate company directly acquired, owned, and actively managed income producing properties, it would report active income or losses from these activities.

Q: Explain where Guaranteed Payments show on the Form 1040. Do they show on line 7 of the 1040?

A: Guaranteed Payments are reported in Part II on Schedule E and then carried to Line 17 on Form 1040.

Q: Does a partnership pay FICA and Medicare taxes on Guaranteed Payments?

A: No, the company does not pay FICA or Medicare taxes on Guaranteed Payments. The responsibility for those payments falls on the partner who must pay the full amount, i.e., the company share as well as the employee share of FICA and Medicare.

Q: Please explain passive versus non-passive income again.

A: Active income is income from any of the following:

• Wages, salary, commissions, bonuses, or other payments for services rendered.
• Profit from a trade or business in which the taxpayer is a material participant.
• Gain on the sale or other disposition of assets used in an active trade or business.
• Income from intangible property if the taxpayer’s personal efforts significantly contributed to the creation of the property.

Passive income is income from any of the following:

• Any trade or business or income-producing activity in which the taxpayer did not materially participate.
• Subject to certain exceptions, all rental activities, whether the taxpayer materially participates or not.

In general, if a taxpayer receives income (or losses) from a business but is not an active participant in the business, the income or loss is classified as passive income or loss.

If a taxpayer loses money in a business in which he or she materially participates (non-passive loss), the taxpayer can write off the losses against other income. However, if the taxpayer’s participation is passive, e.g., he or she owns a business but someone else makes all the management decisions, the taxpayer can only deduct the losses from other passive losses.

Q: How do you determine the At-Risk and Basis amounts?

A: Basis and At-Risk for an owner of a Subchapter S corporation is the owner’s net worth in the company plus the dollar amount of loans from the owner to the company.  For a partnership, a partner’s Basis and At-Risk amount is, in general, the partner’s net worth in the partnership plus his or her pro-rata share of partnership liabilities.  For example, if a general partner owned 70% of a partnership, the general partner’s pro-rata share would be 70% of partnership liabilities even though, as a general partner, he or she must assume responsibility for all partnership liabilities.

Q: Since distributions in excess of the basis amount are taxed, where does this difference show?

A: Distributions are taxed at the capital gains tax rate, which means that the amount subject to capital gains taxation would be reported on Schedule D in the personal income tax returns.

January 23, 2014

Q: Can you please explain the section 179 deduction and what it's for and how the IRS calculates it? Is this on a schedule, or does it depend on size of company, etc.?
 
A: The Section 179 deduction is based on qualified fixed asset purchases up to an IRS-defined amount per year.  If a non-Subchapter C company purchases $500,000 or more of qualified assets in 2013, a maximum $500,000 Section 179 deduction is granted to the business owners.  The owners then use the deduction to reduce the amount of taxable company incomethey must report on their Form 1040.

Fixed assets purchased used for this purpose are not included in the fixed asset base the company uses to determine its depreciation expense for the year.  Since the Section 179 deduction is to be used only by the owner or owners to whom it is granted, the Section 179 deduction is not added to company depreciation expense for the year. The amount of the Section 179 deduction never shows up on the company’s accrual financial statements or in computing ordinary business income on business tax returns. Nor is it part of accumulated depreciation on Schedule L.

Q: Why is the $80,000 estimated tax payment on page 2 of the McPherson personal tax return considered cash out?

A: The $80,000 is the total of quarterly cash payments Mr. McPherson made to the IRS on taxable income not subject to withholding.  Mr. McPherson, as the owner, makes these estimated cash payments, not the companies, to satisfy his tax obligation on the earnings of Sandover Contractors, Greater Pacific Realty Partners, and all other sources of income not subject to withholding.Non-Subchapter C companies provide cash via distributions and loans to the owner so he or she can make the estimated tax payments on the company earnings.

Q: Can we rely on the distribution figure from the Partnership Basis worksheet; when we have not received the Schedule K-1?

A: Yes. You might also cross check this source with partnership financial statements, if available.  And you may find more useful information in the Statement of Partnership Capitalor in footnotes to the financial statements.

October 23, 2013

Q: Can you explain the difference between the $709,446 of distributions reported at Line 16d on Schedule K and $37,796 of distributions reported at Line 7 on Schedule M-2?

A:  Line 16d on Schedule K for Information Access, Inc. captures total distributions actually paid to owners during the 2009 tax year in the amount of $709,446.  The owners respective Schedules K-1 confirm that each owner was paid a pro rata share of the total distribution.

The 2009 distributions of $709,446 are used as an offset to any earnings identified as accumulated undistributed earningsduring prior or current years per IRS guidelines.  Note that Line 1 on Schedule M-2 is blank, which means that all taxable earnings prior to 2008 have been previously distributed to owners.  Current year distributions of $709,446 more than offset the $37,796 of undistributed 2009 earnings realized by Information Access, Inc. and reported at Line 6 on Schedule M-2.  The $37,796 reported at Line 7 represents that portion of current year distributions used to complete the offset.

• Please note that the information presented on Schedule M-2 generally has no impact on our analysis of cash flow or taxable income flowing from the business entity to the owners.   

Here’s some additional detail to round out our answer.  The accumulated adjustments account (AAA) depicted in column (a) of Schedule M-2 is an account of the Subchapter S corporation that generally reflects the accumulated undistributed net income of the corporation after 1982.   The $37,796 calculated on Lines 1 through 6 on Schedule M-2 in column (a) combines all current year income sources and subtracts nondeductible expenses to arrive at net undistributed earnings that, coincidentally, roughly approximate current year net income reported according to GAAP accounting.

The specific calculations in column (a) of Schedule M-2 combine total 2009 taxable Ordinary Business Income of $112,576 at Line 2 and taxable Interest Income of $421 at Line 3 with any prior undistributed income at Line 1.  We then subtract actual expenses incurred during 2009 but not allowed as deductions for Information Access, Inc. in the amount of $74,780 – Charitable Contributions of $2,872 plus Excluded Meals & Entertainment of $71,908.  The net of these three amounts is $37,796 reported at Line 6.

The $37,796 of ”Distributions other than dividend distributions” reported at Line 7 on Schedule M-2 representsthat portion of 2009 distributions made by Information Access, Inc. used to offset the amount calculated on Line 6.  This approach is as prescribed by the IRS to indicate that no earnings were retained by the Subchapter S corporation.  This calculation is unique to Subchapter S corporations.

October 10, 2013

Q: In referring to Schedule B information, would you include interest income from Sandover Contractors Inc, even though Mr. McPherson has ownership interest in the company? Wouldn't you consider the interest paid to Mr. McPherson as discretionary income? Why would you include interest income from Sandover, but not from Greater Pacific Realty Partners?

A: The $20,085 interest income from Sandover Contractors to Mr. McPherson reported on his Schedule B was actual cash interest paid by the company to him.Whether the interest might be considered a discretionary payment or not doesn't really matter.  Our first purpose is to define cash and non-cash earnings for Mr. McPherson.  The interest payment was cash to McPherson per the terms of the loan he made to the company,and we accounted for it as cash income.

Whether we included it as sustainable cash income is a separate issue.  Please recall that later in our analysis we included this interest payment as one of the cash paymentsfrom Sandover Contractors excluded from McPherson’s personal cash flow in determining the extent of his reliance on Sandover.  

The $4,567 interest income channeled from Greater Pacific Realty Partners via their Schedule K-1 to Mr. McPherson represents his share of interest income earned by the partnership.  Note that the cash interest income went to the company and not to Douglas McPherson.Mr. McPherson must report his share of the interest earnings as taxable income. Keep in mind that any designation "From K-1" means that the amount is a pro-rata share of company income or expense and is not actual cash received or spent by the taxpayer.

Q: You commented on the $18,285 in cash Mr. McPherson received on the sale of the Aetna Life Assurance stock but you never brought it into play for the cash flows. Should it have been considered?

A: Our description on how to treat the cash proceeds of the stock sale invites us to be conservative in how we handle the cash flow in our analysis.  We used the conventional approach on Slide 51 by limiting the cash flow recognized to the net gain of $4,241 realized on the sale.  We later acknowledged on Slide 52 that there may be merit in using actual cash proceeds instead.  Please recognize that this cash flow is not likely sustainable (or predictable) so we don't use cash capital gains to estimate sustainable cash revenue.

Q: What would trigger a question to ask for Schedules K-1?

A: Anything on the personal tax returns that mentions "From K-1", anything reported on Schedule E/Part II, or any reference to Schedules K-1 in a supporting statement indicates there areSchedules K-1 that source taxable income, deductions, or cash payments for the individual being analyzed.  If you’re aware that the individual you’re considering as a potential guarantor or borrower has an ownership interest in a partnership, Subchapter S corporation, or an LLC, ask for the Schedule K-1 issued by the business.  In general, it’s always a good practice to ask even if it is not apparent that Schedules K-1 may exist.

Q:  What is considered taxable income?

A: Taxable income is specified by the tax code. The code and supporting regulations are the IRS instructions that spell out what is to be included as taxable revenue and deductible expenses in completing either personal or business income tax returns.

Q: When calculating personal cash revenue is the $345,245 from the Schedule Efor a Subchapter S corporation actually cash income that he could put in his pocket?

A: The $345,245 identified as cash flow to Mr. McPherson from Sandover Contractors is the sum of a) cash distributions of $251,575, b) a stockholder loan repayment of$86,863 reported on the Sandover Contractors Schedule K-1, plus c) the proceeds of a new company loan made to Mr. McPherson during the year in the amount of $6,807.  The entire amount is indeed cash to Mr. McPherson, and none of it is reported as taxable income. 

Q: Is there any instance when a distribution to an individual would be taxable income? For instance, if the distribution on the K-1 is greater than the related income/loss reported on Schedule E would any portion of the distribution be taxable?  I’m trying to understand why distributions are not taxable (outside the obvious of loans to an entity) at any level? Or are they?

A: A distribution is subject to tax as a deemed dividend if it exceeds an owner's or partner's "at risk" position in the company.  The definition for "at risk" varies by type of company.  For a Subchapter S corporation, "at risk" is the owner's share of company net worth plus the amount of loans from the owner to the company.  For a partnership, a partner's "at risk" is his or her share of partnership net worth plus his or her pro-rate share of a) qualified non-recourse loans and b) recourse loans.

Using the material in the webcast, we see that McPherson's "at risk" position in Sandover Contractors at the end of 2007 was company net worth of $1,673,286 (see the company balance sheet and recall that he owns 100% of the company) and loans from McPherson to the company of $197,417 for a total of $1,870,703.  McPherson could withdraw that amount of cash from his company as distributions on a tax-free basis.

With respect to Greater Pacific Realty Partners, we can use information from the Schedule K-1 (Form 1065) to identify the potential amount of distributions available on a tax-free basis.  The information at Lines K and L indicate McPherson's share of qualified non-recourse and recourse financing at the end of 2007 was $1,873,690 while his ownership share of the partnership's net worth was $380,610.  The sum of those two amounts is $2,254,300.  This is the amount of additional distributions McPherson could take on a tax-free basis.

The rules that govern distributions are embedded in the income tax code and provided in the IRS regulations and instructions for preparing personal and business income tax returns.  They reflect acts of Congress.

August 1, 2013
Q:  How do you determine whether the distributions are either cash or property on the Form 1120S?

A:  Distributions are generally cash distributions to owners. If not, they have same impact on the company, i.e., deplete its assets while providing owners with tax free income. To be certain whether any distribution is in the form of cash or property (non-cash), we need to ask the accountant or owner.

Q:  Will guaranteed payments equal the salary amount on the 1040?

A:  No they are not included on Line 7 (Wages and Salaries) on the Form 1040.  Rather they are reported separately in Part II on Schedule E in the taxpayer’s personal income tax returns.

The partnership reports guaranteed payments at Line 10 on Form 1065 as a business expense. They are also reported at Line 4 on Schedules K and K-1 of the partnership return. The individual partner reports guaranteed payments at Line 28 on Schedule E in Column J as ordinary income, along with his or her distributive share of the partnership's other ordinary income. The total amount from Schedule E, Line 41, will be transferred to Form 1040, Line 17.

Guaranteed payments are treated like salary and reduce reported income for a partnership by the amount of the guaranteed payment.  The partner receiving a guaranteed payment must declare the amount as taxable income on his or her personal income tax returns.  

Q: What does passive and non-passive income signify(Subchapter S corporation versus a partnership)?  Does passive or active income refer to the type of business organization?

A:  Passive and non-passive (active) income definitions are the same for Subchapter S corporations and partnerships.
Non-passive income is defined as any of the following:

• Wages, salary, commissions, bonuses, or other payments for services rendered.
• Income from a trade or business in which the taxpayer and owner is a material participant.

Passive income is defined as any of the following:

• Income from any trade or business or income-producing activity in which the taxpayer and owner did not materially participate.
• Income from all rental activities, subject to certain exceptions, whether the taxpayer and owner materially participated or not.

Q:  Just curious. I see owners frequently taking out distributions and injecting that back into the company in the form of loans vs. equity. Do you know the reason for this?

A: If an owner loans money to his or her company, it usually represents emergency financing.  That is, the company has likely exhausted all other possible sources of funding and, therefore, is compelled to rely on funding from an owner or owners in the form of a loan to the company. Since the financing support from the owner took the form of a loan rather than a capital injection, the owner implicitly expects to be repaid for the amount he or she has advanced to the company.

On the other hand, money loaned by a company to its owner or owners are considered loans from a company to an owner as owner compensation, since such loans are rarely repaid.  If a company is organized as a Subchapter S corporation, partnership, limited liability company, or sole proprietorship, any reduction in the loan balance usually reflects a partial or complete conversion of the loan to distributions or withdrawals.  If the company is organized as a Subchapter C corporation, any reduction in the loan balance frequently reflects a partial or complete conversion of the loan to compensation.  

In neither instances does cash change hands at the point of conversion.  Cash leaves the company when the loan is made.  It does not return to the company if and when the loan is reclassified as a distribution, withdrawal, or owner compensation.

Q: In the Credit Refresher on Schedule K-1 (Form 1065) it states that net rental income is prepared according to IRS preparation guidelines but capital accounts are calculated according to GAAP.  Why?

A:  Since business income tax returns are prepared in accordance with tax legislation and regulations and company financial statements are prepared in accordance with GAAP, the recorded amounts for revenue and expenses on the two statements generally differ. However, the income tax regulations specify that all balance sheet amounts reported on Schedule L conform to the company’s books, i.e., to the company’s accrual balance sheet.  Therefore, taxable income will differ from accrual income but balance sheet information on business income tax returns and on accrual financial statements will be (or, at least, should be) identical.

With respect to a partner’s capital accounts at Line L in Part II on Schedule K-1, the IRS offers the taxpayer several options for recording the information.  The taxpayer can report his or her capital account information on a tax basis, on a GAAP basis, on a Section 704(b) book basis, or on some other basis identified and explained by the taxpayer.  The reasons for these options rest with the Congressional legislation that established the income tax regulations and associated income tax preparation guidelines.

Remember, all income tax returns are really political documents reflecting acts of Congress, which may establish rules far different from those applied under generally accepted accounting principles (GAAP).

July 25, 2013

Q: When we consider living expenses, please let me know reasonable way to estimate living expenses when these are not provided (e.g. 18% of income).

A: There is no practical rule of thumb that we can consistently apply to define individual living expenses in the absence of information from the individual for two fundamental reasons:  1) every individual and family and their personal financial priorities are different and 2) depending on the type of business, an individual or guarantor may choose to run the majority of living expenses through the company, e.g., farm operations.
 
If any guidance exists it comes in a calculation that might allow us to “back into” an estimate of living expenses.  The present average savings rate is roughly 5% of disposable income. Conversely, that means that living expenses are 95% of average income after taxes.

Please recall that we’re measuring the value of a guarantor or potential guarantor’s cash flow, and it’s important that we use cash income after taxes in applying this logic.  Take advantage of the Personal Cash Flow Worksheet included in the course materials by modifying the sequence of the template.  Simply deduct Cash Taxes from Cash Revenues before adjusting for Living Expenses and Personal Debt Service.

Q: If there were Capital Distributions on Schedule D, would you have included that as cash to the individual?

A:  Capital distributions associated with mutual fund investments are usuallycash distributions. Look for a tax return supplemental statement that clarifies if the distributions are cash or are reinvested.   General rule of thumb about Schedule D – attempt to verify every number with additional information if possible.

Q: Do you offer a Freddie Mac – real estate for secondary market course – or Fannie Mae for the self-employed borrower?

A:  We do not presently offer webcasts on these topics.

Q:  How did you determine that the $20,085 from Schedule B was a cash expense but the other two were not?

A:  Douglas McPherson’s Schedule B reported interest earnings totaling $25,653 for which he is responsible for paying federal income tax.  

In identifying Personal Cash Revenue derived from the three interest payments received, we included the interest received on McPherson’s loan to Sandover Contractors in the amount of $20,085 and interest paid to Mr. McPherson by Coast Savings on his CD in the amount of $1,001.Combining both sources determines Mr. McPherson’s total interest income cash flow as $21,086, which is then usedin estimating Personal Cash Revenuesince these interest payments went directly to McPherson.  

We excluded the $4,567 of interest income passed to him from Greater Pacific Realty Partners in the calculation of McPherson’s Personal Cash Revenue.  This interest income was reported on Line 5 of the partnership’s Schedule K-1 transferring responsibility for taxes on the interest payment to Mr. McPherson – cash income to Greater Pacific Reality Partners but not to Douglas McPherson.

Q: Where did the $5,100 of tax free interest income come from?

A:  The tax exempt interest income totaling $5,100 reported on line 8b of Mr. McPherson’s Form 1040 represents interest on the municipal bond issued by Portersville, CA and listed in Note 1 of his Personal Financial Statement.  It’s important to note that although this payment is not taxable, it is indeed cash flow paid directly to him.  

Q:  Where did you find the loan from the corporation?

A:  The two loans from Sandover Contractors, Inc. to Douglas McPherson are recorded as Current Assets on the company’s December 31, 2007 balance sheet.  The loans are identified as Notes Receivables – Stockholders for $22,508 and Due from Stockholders for $27,097.Note that the $6,807 increase in Due from Stockholders was included in McPherson’s 2007 cash revenues from Sandover Contractors, Inc.

Mr. McPherson identifies both as Other Debt on his Personal Financial Statement.  Both are further acknowledged in Note 5 to his Personal Financial Statement as Notes Payable – Sandover for $22,508 and Advances – Sandover for $27,097.

Q: How did you determine that interest income on schedule B from Sandover was cash, and income from Greater Pacific was not?

A: The quick way is to look for the designation "from K-1" or "from Schedule K-1".  That means that the amount in question was passed through to the taxpayer.  The company or partnership earned the cash interest income but the owner or partner is responsible for paying the income tax obligation on that amount, which he or she must claim as taxable revenue.

You may find a supporting schedule to the personal income tax returns that further clarifies the source of the amount reported on Schedule B.  In addition, review all Schedules K-1. Any amounts reported on those schedules and carried back to the personal income tax returns are non-cash amounts for the taxpayer (except for guaranteed payments to partners).

The interest income from McPherson's loans to his company - $20,085 - is cash interest income directly to him.  If it had been interest income earned by the company and passed to him, there would have been a comment on Schedule B to the effect of "from K-1" and you would find the same amount at Line 4 in Part III of Schedule K-1 (Form 1120S) for Douglas McPherson.

May 1, 2013

Q: Is the basis calculated at the beginning of the fiscal year or at the end?

A: The “basis” and “at risk loss limitations” calculations are completed at the calendar year-end because all individual tax returns (Form 1040) and pass-through entities (Form 1120S and Form 1065) must have a December 31 year-end date.

They are calculated at the end of the year because we must ensure that the net worth of the current year is used in the formula for “basis” at “at risk loss limitations”.

Q: Is the maximum loss against "at risk" amounts based on an annual basis OR is the maximum loss on a running sum basis year over year against total "at risk"?

A: The maximum “at risk loss limitations” are used against a year in which the entity is profitable, and the dollar amount of the loss that can be taken in a given year is a function of the “at risk loss limitation” calculation and the amount of loss carrybacks or carryforwards that a company may have from previous years.  

Q: Where are you from?

A: I am from the great state of Maine, accent and all!  

Q: You mentioned that we wouldn't discuss Part II of the 1065 K-1, but I'm still curious about how cash flows are treated for varying entities.  

I have seen quite a few Schedules K-1 where the partner type is listed as “Fiduciary”, “Trustee” and even “401K”.  How do we view the cash flows and/or contributions in those cases?

To be more specific, let’s say my guarantor is an individual and he has numerous “Fiduciary” Schedules K-1 with significant distributions.  I assume I wouldn’t include those in my guarantor analysis?

A: You must be referring to estate administration and the general duties of a personal representative, be it an executor, an administrator or a trustee, following death.

A “fiduciary” is an individual or trust company that acts for the benefit of another. Trustees, executors, administrators and other types of personal representatives are all fiduciaries.  Distributions these fiduciaries receive may be exclusively for others or, in part, for the fiduciaries themselves.  It all depends on the terms of the estate administration as to whether a particular individual benefits from the estate and, therefore, from the distributions.

In the absence of information on this issue, I would agree that it is prudent to exclude such distributions from guarantor analysis.

Q: I have questions about how to appropriately determine cash flow from a Tax return. We have a form that we use here in the bank. However, after today I believe it is greatly overstating cash flow from an individual.

A: You are correct, we must be careful on an individual Form 1040 tax return to distinguish between the cash and non-cash items when that individual is responsible for the taxes on one or more pass through entities (partnership, S Corp, LLC, etc.).

We explore these issues in detail in our webcast on Personal Income Tax Returns which will be conducted two more times in 2013 (we should have the schedule posted on our website, www.shockproof.biz, by the middle of May).

As an alternative, you may want to consider our previously recorded session on Personal Income Tax Returns which can also be found on our website. Click on this link for further information.

April 11, 2013

Q: Are you going to cover "passive" and "non-passive" income /loss and how to deal with those to see cash flow?

A: Non-passive income is defined as any of the following:

• Wages, salary, commissions, bonuses, or other payments for services rendered.
• Income from a trade or business in which the taxpayer and owner is a material participant.

Passive income is defined as any of the following:

• Income from any trade or business or income-producing activity in which the taxpayer and owner did not materially participate.
• Income from all rental activities, subject to certain exceptions, whether the taxpayer and owner materially participated or not.

However, whether income is passive or non-passive is immaterial when calculating cash flow. It all gets back to cash distribution and loans to owners. Cash distributions are recorded on the Schedules K-1, and loans can be identified from the company financial statements. So, in effect, forget about passive and non-passive income or loss and identify the cash flowing from the company to the owner.

 

January 31, 2013
Q: Is the personal property loss on Schedule Eof $35,774 just a coincidence or are the property and the partnership related?

A: It is indeed just a coincidence thatthe $35,774 tax loss on Schedule E, Part Iof Peter Keys’ Form 1040 is identical to the passive income of $35,774 for Information Access Partners located on Schedule E, Part II. The properties are not related.

Q: Why wouldn’t the partners simply take the money as a salary verses guaranteed payments?

A: A guaranteed payment to a partner is a legally binding amount of compensation that the partnership is obligated to provide the partner regardless of the financial fortunes of the partnership.  If the partnership loses money, it is still obligated to pay the full amount of the guaranteed payment.  If the partner in question drew a salary only, he or she may find their salaries adjusted downward in the face of financial difficulties encountered by the firm.
It might be helpful to note a standard definition of guaranteed payments to partners, as follows:

• Guaranteed payments are payments that are guaranteed to be made to a partner irrespective of whether the partnership makes a profit or not. Guaranteed payments to partners are made to ensure that partners are compensated for specific contributions they make to a partnership, whether in the form of goods or services. This eliminates the risk of their making personal contributions of time or property for which they are never paid if the partnership is not successful.

Q: For distributions, when computing the at risk/basis figure, how do you determine the accrued net worth of the owner/partner?

A: In general, the basis figure for an owner or partner is his or her pro-rata share of partnership capital on the accrual balance sheet of the partnership, since the partnership capital account on an accrual basis includes non-deductible expenses and tax-exempt interest income.  The latter two amounts may or may not be reported in compiling the partner’s capital account on Schedule K-1 (Form 1065).

A partner’s “at risk” position is the sum of his or her basis and the partner’s share of partnership liabilities, which is generally determined by the partner’s share of partnership capital.

The same general concepts and computations hold for owners of a Subchapter S corporation, except that loans from an owner to the company are included in the “at risk” figure for the owner while company loans guaranteed by an owner are excluded from the “at risk” amount.  In effect, loans from owners are considered to be quasi-equity.  This classification does not apply, however, to partners in a partnership. That is, loans from partners to the partnership are not included in “at risk” computations.

For both partnerships and Subchapter S corporations, capital contributions increase “at risk” and net worth, accrual company income increases “at risk” and net worth, accrual company losses decrease “at risk” and net worth, and distributions to partners and owners decreases “at risk” and net worth.

It either case, it is always a good idea to check any calculations you make with the customer and/or the accountant.

Q: Are distributions considered to be a reduction of partnership earnings or a reduction of capital?

A: Distributions decrease the owner’s accrual net worth and, therefore, the owner’s basis.  They immediately decrease partnership earnings and, in so doing, decrease partners’ capital or accrual net worth.

Q: Will you send the upcoming schedule in your follow up email?

A: We will send a partial list of upcoming webcasts with the follow-up email.  However, for a complete list, please check the schedule on our website at www.shockproof.biz.

Q: Why wouldn't the company show the cash to the owners as a repayment to the shareholder loan as opposed to just a large cash distribution? Said differently the same thing could have been accomplished, but make the company look slightly better.

A:Schedule L in the business income tax returns indicates the company did repay $232,000 of the $363,164 of loans from owners in 2009.  And, indeed, if it had paid down the remaining $131,164 of loans from owners in 2009, reducing 2009 distributions by that amount, the company’s leverage would have been slightly lower at 11.79 than it actually was at 15.21.

There may have been a subordination agreement in place that limited the amount of debt repayment to owners.  From the owners’ perspective, the mix between loan repayments and cash distributions is really immaterial since neither is a taxable event to the owners.  And, certainly, in the next period, i.e., in 2010, we would expect the company to fully pay down the remaining $131,164 amount due to the owners.  We would also expect the sum of loan repayments and cash distributions in 2010 to approximate the 2009 cash outflow in the amount of $941,446 – cash permitting.

To fully resolve the issue you raise, we would need to ask the owners or ask the company’s accountant, since the reason for the mix between loan repayment and distributions in 2009 is unclear.  But we might conclude, nevertheless, that the owners were not particularly concerned in 2009 about the impact of their very large cash withdrawals from the company on the company’s risk profile.  If that concern were paramount, they would certainly have limited the sum of loan repayments and distributions to a far lesser amount – assuming, of course, that their respective lifestyles did not dictate a minimum level of cash inflow from the company.

January 24, 2013

Q: What is the other non-cash component of the $542,933 on line 17 -- $483,985 is from the business - what is the rest?

A: The $542,933 at Line 17 on Form 1040 is sum of a) the loss of $23,008 reported in Part I on Schedule E, b) $81,946 of the net business income from Greater Pacific Realty Partners (McPherson's pro-rata share) reported in Part II on Schedule E, and c) $483,995 (after the $125,000 Section 179 deduction) of net business income from Sandover Contractors, Inc.

Questions & Answers - Schedules K-1 Webcast - October 17, 2012

Q: Is there an easy way to figure out an owner's cash contributions to the Subchapter S Corporation?

A: There is no information on the Schedule K-1 (Form 1120S) that addresses an owner’s cash contributions to the company.

Therefore we must check the balance sheet (Schedule L) on the business income tax returns and reconcile net worth for the year in question. Alternatively, we can review Schedule M-2 on the business income tax returns, which also reconciles changes in net worth. In addition, we can review the company’s financial statement, which would reveal owners’ contribution to the company and should match exactly the information in Schedule L on the business income tax returns.

Q: Doesn't the Form 1120S show distributions/withdrawals?   

A: Yes.  Form 1120S does capture distributions, which are reported on a pro-rata basis on each Schedule K-1 at Line 16D.   

Q: What is the difference between passive and non-passive sections for cash purposes?

A: A passive activity involves the involvement of a trade or business in which the taxpayer does not materially participate.   In either event, Schedule K-1 will indicate the cash amount.

The issue of passive/non-passive income comes into play with respect to a taxpayer’s ability to offset losses. Passive losses are not generally deductible as net losses against other income items. They are deductible against passive activity income only. Similarly, non-passive losses can be offset against non -passive income but are greatly restricted in offsetting against passive income

Q: So an owner only pays taxes on non-passive income?   

A: An owner pays taxes on both passive and non-passive income. However, a company owner is highly restricted in using passive income to offset losses. Non-passive income is needed to offset losses to any significant extent.   

Q: In computing the basis, would you also subtract out any shareholder loans from the company to the owner?   

A: No, loans to owners are not subtracted in computing basis. However, the IRS may apply certain criteria (in an audit) and reclassify loans as distributions. In that event, the basis would decrease.   

Q: On the Key's Cash Flow, you didn't include the $1,555 in dividends as cash flow.  Why not?   

A: In this seminar, we are not building Keys' personal cash flow but, rather, showing where cash amounts on Schedules K-1 appear or do not appear and how they contrast with taxable income.   If we were constructing a personal cash flow statement, we would indeed include $1,555 of cash dividends in the personal cash revenue section of the statement.

Q: Should we exclude the $91,967 non-passive income from Peter Key’s Schedule K-1 (Form 1120S) from cash available to service debt?

A: The $91,967 in non-passive income, if cash, is available to Information Access, Inc. to service debt.  However, it is non-cash to Peter Keys, representing his pro-rata share of company income on which he must pay taxes.  

Q: On Slide 27 you show the distribution as a "property distribution" on the Schedule K-1 (Form1120S) and on the Schedule K-1 (Form 1065) there are separate "cash and property distributions". What is the difference?

A: The Schedules K-1 for Form 1120S and Form 1065 are different regarding distributions.

On Schedule K-1 (Form 1120S) Line 16D reports Property Distributions which, usually are in the form of cash, could also be property distributions. The only way to be certain of the exact composition of the distribution is to check with the taxpayer/accountant.

Concerning Schedule K-1 (Form 1065) the distribution issue is much clearer as Box19A lists distributions in the form ofcash and marketable securities while Box 19C contains other property.

Q: On Information Access Inc.'s Form 1120S, Line 7 on Schedule M-2 shows only $37,796 in distributions. We know that distributions total $709,406. Why is this?

A: The $37,796 represents the amount of retained earnings remaining on a tax basis for the year ended December 31, 2009, which was completely depleted by distributions.  Only the amount needed to deplete existing retained earnings is captured at Line 7 on Schedule M-2 even though the full amount was, as you noted, $709,406.

On an accrual basis, after the $709,406 cash distribution, 2009 retained earnings were ($510,096) as reported on Statement 14.

• Retained earnings beginning of the year            $86,874
• Plus Net income per books                                 112,476
• Minus Distributions                                           (709,446)
• Retained earnings end of the year                     ($510,096)

Q: How do we know what liquidity Sandover Contracts currently has?

A: At any point in time, Sandover's liquidity is the amount of ready cash it has on its balance sheet.  I different issue is the amount of surplus cash flow (if any) it generated historically and the amount it is projected to generate in the future.  But when it comes to strict liquidity, in the short run it is the amount of ready cash on hand.  

In the longer run and in a liquidation scenario, it’s the cash liquidation value of all company assets offset by the debt obligations of the company.  I think it's useful to note the time horizon, e.g., short run vs. long run liquidity.

Q: Can you explain again IRA and 401k are not liquid assets?

A:  Retirement funds are the last place that an individual would go for cash.  Up until age 59 1/2 a penalty is incurred if those funds are withdrawn.  In addition, income taxes have to be paid on any amounts withdrawn (unless it is a ROTH IRA).  The financial institution cannot require that an individual withdraw money from retirement funds.

Q: On schedule D, do we know that the sale of the stock was not reinvested in other equities? What if this was a large stock sale?

A: We don't know and we really can't know without specifically asking the individual.  What we can figure out, usually, is the amount of cash that came in or went out in the year in question because of the sale.  That contributes to this year's cash flow (assuming it was a cash inflow).  But if there is a personal cash flow surplus, we do not know how it was used.  We can only guess by examining personal assets stated on the PFS.  And because of the uncertainty of sustainable cash inflows or outflows from equity sales, we don’t consider them-recurring in building a likely personal cash flow statement to help service borrower debt in the coming year

Q: In Schedule A we are including $15,532 in real estate taxes. Is this amount separate from the $2.526 property taxes on schedule E.  If not, are we double counting taxes?

A: The $2,526 on Schedule E is taxes paid for the rental property and is a tax deductible expense for the investment property.   The $15,532 reported on Schedule A is taxes paid for the personal residence, and, as such, is a tax deductible expense.   We did not double count.

Q: Capital gain cash flow-how do we determine if it is non-recurring and do not add to the cash flow?

A: We are calculating the cash flow for the current year.  If we were projecting sustainable personal cash flow, we would consider the sale to be non-recurring, unless investing was the individuals primary line of work.  The size of the sale is irrelevant.

In order to calculate the current year’s cash flow, if the asset were purchased prior to the present year, use this year’s sales price.  That represents the cash inflow from the sale of the asset this year and is a cash inflow to the individual this rear, regardless of whether there is a gain or loss on the sale.

If the asset were purchased in the current year, use the difference between the purchase price and the sales price to capture the net cash flow to the individual for the year.

Q: If the client sold some property during the year and it is reported on the tax return (4797 form?), how do you calculate the cash flow from the transaction?

A: Use the information on Form 4797 since it generally provides acquisition and sales dates along with the gross sales price.  In effect, much of the information on Form 4797 is identical to the information captured for the sale of stocks and bonds, which is captured directly on Schedule D. The information captured on Form 4797 flows to Schedule D, but it provides the underlying data for a gain or loss that we need to compute the cash flow for the year in question.

There are other types of capital gains or losses the flow from Form 4797 to Line 14 on Form 1040. Again, the information on Form 4797 and other schedules supporting that information should be sufficient to identity the cash flows.

Q: Is this the process you always go through with this type of client. Is there any shortcut to get a good overall view of the borrower?

A: There really is no shortcut.  You need to get all the personal income tax returns, all the Schedules K-1, all the relevant company financial statements (to identify loans to owners) and so on.  What we do in this Personal Income Tax Return webcast is to cut through the terminology to show how you identify the relevant cash and non-cash amounts.  Other than that, there are no short-cuts.

Q: During the webinar, we were given that approximately $79,434 was owed in taxes in 2006. After looking through the slides, our assumption is these 2006 taxes were paid in 2007. This makes sense. As lender, is there anyway we would know if the 2006 taxes were not paid? Besides for the obvious case that the borrower is forthcoming with this information, or includes it on their Personal Financial Statement.
 
A: In Step 8 of the exercise, we provided the information that McPherson reported $79,434 at Line 76,434.  That is the amount that he owed for 2006 Federal income taxes (in addition to any amounts withheld and estimated taxes for 2006 paid during 2006).  That $79,434 should have been paid when he filed his 2006 tax return, presumable no later that April 15, 2007.

There is really no way of knowing if a taxpayer paid the amount due other than asking the taxpayer or his accountant, as you suggest.  We assumed he did in the exercise, but we may find that McPherson failed to make the payment for any number of reasons.  However, that information could only come from him.  The IRS wouldn't reveal it to an outside party.  The income tax returns focus on amounts due in the present financial year and do not capture past amounts of federal income taxes paid in the current year.

However, if the amount due were a state income tax, then the federal income tax returns would pick it up - if paid - since the taxpayer can deduct state and local income taxes paid in cash on his or her federal income tax returns.  In this instance, however, the amount due is a federal income tax amount.

Q: We have a spread system that takes us through line by line for the most part to determine what information from the tax return and/or financial statements we need to determine cash flow. I have a couple of questions as to why things are counted or not counted.  I know you’re not the designers of the software; however I’m new in the industry and am unsure if the answer is software specific or more general in nature.
 
1) Health savings account deductions/distributions (Form 8889 correlated to 1040 Ln 25).    Neither the deduction nor the distribution is counted, but this does represent a cash outflow/inflow to the customer – why aren’t these items counted?

2) Nondeductible IRA (Form 8606/loosely correlated to 1040 Ln32.   IRA contributions that are deductible and listed on line 32 are counted as expenses, but nondeductible contributions that are not listed on this line are not counted – since we’re concerned with cash flow and not the tax impact of a contribution, why is this?
 
A:  1. I suspect the software does not capture HSA contributions because the contributions are frequently made by a third party, e.g., an employer, and do not come from the taxpayer.  However, distributions are used in whole or in part to pay for qualified medical expenses.  As such they represent a cash inflow to cover a prior expense or a cash inflow that covers a prior expense and leaves something over for the taxpayer that represents taxable cash income.  Either way, the distribution is a cash inflow, in effect, to the taxpayer.

2. With respect to non-deductible IRA contributions, those are indeed cash outflows and should be classified as such.  Whether the contributions are taxable or not seems besides the point in constructing a cash flow statement.

Your issues are very relevant and they do point up another pitfall or two in constructing and using a personal cash flow statement.  I've always considered a personal cash flow statement as useful for indicating the extent to which a guarantor is dependent on cash flows from his or her company...and for little else.  The amount of cash a guarantor can provide to support company debt service in a crisis is best estimated by reference to a current set of bank or broker statements that indicate a guarantor's liquid personal assets.  In a pinch, it's the guarantor's liquid personal assets that count and not personal cash flow, which is always suspect.

Questions & Answers, Understanding K-1’s, July 19, 2012

Q: Even though Line 16D on 1120S is a "property distribution", is it really a cash distribution?
Q: You said that the $581,746 of property distribution on Form 1120S was cash to Peter Keys, but it is not a cash distribution so shouldn't property distribution be considered non-cash to Peter Keys.

A: On Schedule K-1 (Form 1120S), all distributions recorded on Line 16 under the “D”designation are property distributions.  Think of property as assets. Therefore, the distributions could be any company asset to which the company can attach a value.

Although there are exceptions, virtually all distributions are cash distributions or assets that can be readily converted to cash.  Keep in mind that distributions serve two objectives.  First, they provide cash to owners necessary for them to pay the income tax obligation on company profit for all non-Subchapter C corporations.  Second, to the extent the distribution exceeds the income tax obligation, it serves as tax-free cash revenue to the recipient.  

Obviously, if you are an owner facing an income tax obligation, you want the distribution in cash.   But the only way we can really be sure the distribution was a cash distribution is to ask the owner or ask the accountant.  

Regardless of whether a distribution is cash or non-cash, it has the same impact on retained earnings and net worth. Both decrease by the amount of the distribution.

Q: How can a partner change from passive to non-passive status to take advantage of losses?

A: For an individual to establish non-passive status in a real estate business, he or she must materially and actively participate in the business as well as meet the criteria for a real estate professional.  The IRS defines a real estate professional as someone who a) performs more than 750 hours of active service in real property trades or businesses and b) spends more than half of his or her professional service time during the year in real estate trades or business.  

Even if an individual actively participated in managing or running a partnership but did not meet the standards for a real estate professional, he or she would not qualify for non-passive status.  In effect, it is not simple to make a passive to non-passive transition.

Q: Referencing the rental deposit, is it correct that the rental deposit is a cash flow item but not included in the at risk calculation?

A: In the case of Information Access Partners, the accountant excluded the $268,000 rental deposit from the “at risk” calculation.

However for the years in which the rental deposits were received by Information Access Partners, the rental deposits were indeed a cash inflow.  The company would debit cash on the asset side of its balance sheet and credit rental deposits on the liability side.

However, note that for the year in question the rental deposits were the same at the beginning and at the end of the year. As a result, there was no 2009 cash impact of rental deposits, i.e., no cash inflow or cash outflow associated with rental deposits in 2009.

Q: Please confirm that "guaranteed" payments on partnership K-1 is an actual cash event as is a distribution.  Is it discretionary?

A: Guaranteed payments are determined by the partnership agreement.  A guaranteed payment is very similar to salary.  In fact, think of it as guaranteed compensation for the partner or partners in question.

The partnership pays the guaranteed payment throughout the year – or as agreed to – and reflects the payment as an expense on its income statement.  It is definitely a cash event.  However, the partnership does not withhold income tax or Medicare and social security contributions from the guaranteed payment amount.  The partner is responsible for making all those payments via estimated income tax payments and payment of the self-employment tax.  A partner receiving a guaranteed payment reports the amount in Part II on Schedule E, which flows into Line 17 on Form 1040.

There is nothing discretionary about a guaranteed payment.  It is an agreement between the partnership and the partner.  The partnership is obligated to pay the amount regardless of its profit and loss position.

Keep in mind that not all partnerships offer guaranteed payments and not all partners receive guaranteed payments.  Whether a partner receives a guaranteed payment may depend on the partnership’s interest in providing a specific amount of compensation to assure it retains the partner or partners in question regardless of the partnership’s operating performance.

Q: What is the difference between qualified recourse and non-recourse lending?

A:  If the debt is non-recourse then the lender cannot collect or attempt to collect from the business owner.  The owner has no responsibility for the debt in question.

Qualified non-recourse debt means, in effect, that the lender does have recourse to the individual, especially if the debt were secured by real property.   If a taxpayer reports amounts as qualified non-recourse debt, it usually means that he or she has guaranteed those amounts.  In fact, a general partner in a partnership is, by definition, liable for all partnership liabilities.   

In many states, there is a single action rule, which states that in the event of default, the lender may choose to foreclose on the collateral or require the guarantor to honor the guarantee, but may not pursue both courses of action.   If the lender decides to go against the guarantor instead of attaching the collateral, qualified non-recourse debt becomes recourse debt by virtue of the lender’s decision.  However, if the lender decides to go after the collateral, qualified non-recourse debt becomes non-recourse debt.  The guarantor is off the hook in a single action rule jurisdiction by virtue of the lender’s decision to proceed against the collateral.  

It is wisest, and certainly most conservative, to assume that qualified non-recourse debt is full recourse, which it may easily be if it appears that the guarantor has more cash available than might be realized from sale of the collateral.

Q: The case study did not discuss treatment of contributions to both Subchapter S corporations and partnerships. Would like your thoughts.

In constructing a personal cash flow statement for an individual or guarantor with ownership interests in either a Subchapter S corporation or partnership, we net loans from owners and capital contributions from owners against distributions to owners and loans to owners from those companies.  We do so since we are attempting to estimate personal cash revenue from all sources and match it against a) living expenses, b) cash taxes paid, and c) personal debt obligations in order to estimate a personal cash flow surplus, if any, available to support company interest-bearing debt guaranteed by the individual in question.

It is not uncommon to observe loans to owners and loans from owners during the same year.  Generally, loans from owners represent emergency financing for the company, i.e., the company could not meet a cash flow or financing crisis by arranging financing from an arms-length third party so it was compelled to turn to an owner for the necessary cash.  The owner’s cash, in turn, could be used for a vast variety of reasons, such as meeting a payroll shortfall, purchasing inventory, paying suppliers to take discounts, acquiring fixed assets, and so on.  The point is, however, that such cash outflows from the owner – cash inflows to the company – deplete the owner’s personal cash flow and personal cash flow surplus, if any, and therefore reduce personal cash flow available to support company debt.

When we construct a UCA business cash flow statement, we do not net the cash outflows from distributions and loans to owners against the cash inflows from owner loans and capital contributions because one set of cash flows represent compensation and income tax payments – operating expenses – while the other set represents financing.   In constructing a UCA cash flow statement, a very critical consideration is the classification of cash flows into operating cash flow, investment cash flows, and financing cash flows.  A basic objective is to establish if the company did – or can – cover all of its cash operating expenses as well as service its interest-bearing debt from operating or business cash flow.

With the personal cash flow statement, our objective is different.  We want to estimate the amount of personal cash flow available to support company debt, which requires us to account for the net amount of cash revenue from all sources.

Looking forward and attempting to estimate sustainable personal cash flow, we would likely discard loans and capital contributions from owners unless there were a capital contribution schedule or requirement built into a partnership agreement. 

Questions & Answers, Schedules K-1, April 24, 2012

Q: If the partner of the partnership is an LLC would you then have to get that LLC's tax returns?

A: Yes, if the entity is an LLC, you should certainly ask for the complete tax return of the LLC, including all Schedules K-1 issued to it.  Only then can you determine the cash flows from the company in question to its LLC owner, although that task usually requires access to the accrual financial statements of all parties to identify loans to and from owners that are not specified in partnership income tax returns.

 Q: If you don't have a K-1, can a Form 6198 provide you with distributions?

 A:  Form 6198 – At-Risk Limitations – is used to figure:

• The profit (loss) from an at-risk activity for the current year.
• The amount at risk for the current year.
• The deductible loss for the current year.

It asks for decreases in at-risk position and defines distributions as an event that decreases at-risk position, but it does not capture distributions explicitly. The accountant may or may not provide the details of an increase or decrease in at-risk positions apart from Form 6198 information. Accordingly, there is no specific information about distributions associated with Form 6198.

Q: Why is the $35,774 passive income from K-1 not included on line 17 of the 1040?

A:  Peter Keyes’ Schedule E Part I records a total rental real estate loss on Line 26 of $35,774.  This amount is offset by passive income from Schedule K-1 of $35,774 recorded in Part II Line 29a.  Accordingly, only the non-passive income of $91,967 recorded in Part II Line 29a is listed on Line 17 of Peter Keys’ Form 1040.

The fact the rental real estate loss is precisely offset by the amount of passive income is simply a coincidence in this instance and causes the confusion.

Q: How do we assume the loan was to Keys and not Smith?

A: Schedule L and Statement 2 to Information Access Partners’ Form 1065 record a $125,000 loan due from a related party.  Peter Keys’ personal financial statement (not included in the download material) also records this loan as a liability.
Without the benefit of the personal financial statement, we would assume the loan was to Peter Keys since he is the majority owner.  But we would certainly check to verify that assumption.
 
Q: On the Schedule K-1 (1120S), how do you tell how much cash may have been contributed during the year to the company?

A: You cannot tell how much cash may have been contributed to a Subchapter S corporation by reviewing the Schedule K-1 (1120S). You must review a reconciliation of net worth and/or the notes to the accrual financial statements in order to determine if any capital injection was made.

Q: Can you please go over Form 4797 and Form 4952 and how they flow through the K-1s to the personal tax return?

Information on Form 4797 – Sales of Business Property – Part I Line 9 would flow through to Schedule D – Capital Gains and Losses – as a long-term gain and/or Part II Line 18b would flow through to Form 1040 Line 14 if an ordinary gain or loss.
 
Information on Form 4952 – Investment Interest Expense Deduction – Line 8 should carry to Schedule A Line 14. However, if any part of the interest expense is attributed to royalties, that amount should be entered on Schedule E.

Q: It was stated earlier that the K-1s are not part of the Form 1040 return and need to be requested in addition to the 1040 return, but isn’t a K-1 required to be filed with the 1040?  If so why would it be a separate request?

A: The Schedules K-1 are part of the information-only income tax returns of an S Corporation (Form 1120S) or for a Partnership (Form 1065).  They are filed by the company or partnership with the IRS.  Therefore, you would need to request the various applicable Schedules K-1, in addition to the Form 1040, in order to complete a thorough analysis of an individual’s cash flow.   

There is no requirement that a Schedule K-1 be filed with a taxpayer’s Form 1040.  In fact, the instructions state that a Schedule K-1 should not to be filed with Form 1040.  But all the relevant information on a Schedule K-1 must be incorporated into Form 1040.  Since the IRS has the Schedules K-1 via the Form 1120S filing by the Subchapter S corporation or Form 1065 filing by a partnership, it can always verify the information on Form 1040.
 
Q: Merely for informational purposes, do you know why there is decreasing transparency with regard to cash in/out as you move between K-1 from 1065, 1120S and 1040?

 A:  You raise an interesting issue of perception.  From a tax preparation perspective, an accountant would likely argue that the various forms capture all the information necessary to properly determine a taxpayer’s obligation, which is the sole purpose of the vast array of income tax forms we encounter.

But from a lender’s perspective, the information content does change.  Schedule L in Form 1120S captures information about loans to and from shareholders, which is essential information for cash flow analysis.  The associated Schedules K-1 (Form 1120S) reports repayments of loans to shareholders.   On the other hand, Schedule L in Form 1065 does not capture information about loans to and from partners, which compels us to look elsewhere for it.  Yet Schedule K-1 (Form 1065) gives us much more information about an owner’s “at risk” position, which points to guarantees and contingent liabilities on the part of the owners or partners.

In the final analysis, the difference likely reflect differences in the tax code and associated regulations that either provide more or less transparency to lenders, who have very different objectives in using income tax information for analysis.

Q: On Form 1120S, Schedule M-2, where does the$37,796 flow and should it be taken out of cash income?

A: Schedule M-2 is a reconciliation of this year’s addition to net worth whereby ordinary business income of $112,155 is increased by portfolio interest income of $421 and reduced by charitable contributions and nondeductible expenses of $74,780 to arrive at this year’s contribution to net worth of $37,796.

Obviously, total distributions of $709,446 far exceeded this year’s contribution to net worth, and, in fact, resulted in an overall negative book net worth of ($510,096).   It is this total distributions amount that we use in constructing the UCA cash flow statement.