Communications

There are few issues more confusing than the use and application of the Section 179 Deduction in computing performance ratios, cash flow proxies such as traditional "cash flow", and actual cash flow in the form of a FASB 95 statement of cash flows or Uniform Credit Analysis (UCA) cash flow statement.

• The Section 179 Deduction plays a role in computing performance ratios and cash flow statements from business tax returns for Subchapter C corporations and sole proprietorships.
• The Section 179 Deduction plays no role in computing performance ratios and cash flow statements from business income tax returns for Subchapter S corporations, partnerships, and limited liability companies(LLCs).
• The Section 179 Deduction plays no role in computing performance ratios and cash flow statements from accrual financial statements regardless of the type of business organization - Subchapter C corporations, the pass-through companies, and sole proprietorships.

The Section 179 Deduction is included with depreciation expense in arriving at a) Ordinary Business Income on Form 1120 for a Subchapter C corporation and b) Net Profit on Schedule C for a sole proprietorship. Therefore, it must be deducted from Cost of Goods Sold or Operating Expenses for any performance ratio whose computation excludes depreciation expense, such as the Gross Margin or SG&A%.

By the same token, it must be removed from the income statement for both of these business organization in computing traditional "cash flow," the FASB 95 statement of cash flow, and the UCA cash flow statement.

If an analyst or lender is using business income tax returns to compute performance ratios and cash flow statements for Subchapter S corporations, partnerships, or LLCs, the Section 179 Deduction plays no role. IRS guidelines specifically state that the Section 179 Deduction must not be included with depreciation expense at Line 14 on Schedule 1120S. Nor may it be included at Lines 16a or 16b as an expense on Schedule 1065. Therefore, it is excluded from all ratio and cash flow computations using these business income tax returns.

With respect to computing performance ratios and cash flow statements from accrual financial statement for any business organization, the Section 179 Deduction is non-existent. It is not an accrual concept and does not appear at any point in a set of accrual financial statements prepared according to Generally Accepted Accounting Principles (GAAP).

With information in the three bullet points readily at hand, an analyst or lender can quickly determine if and when the Section 179 Deduction is used in computing ratios and cash flow statements.

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Since the Section 179 Deduction reported on a taxpayer's Part II / Schedule E is a non-cash expense, in effect, it raises the question about whether the amount of the deduction should be added back in constructing a personal cash flow statement. In other words, a non-cash reduction in Schedule E income reduces personal cash flow, which is intended to capture only cash inflows and cash outflows to and from the taxpayer.

Recall that all taxable income and tax-deductible expenses for the taxpayer are reported in Part III on the Schedule K-1 for the pass-through entities, i.e., for Subchapter S corporations, partnerships, and limited liability companies (LLCs). There are no Schedules K-1 for Subchapter C corporations or sole proprietorships. In addition, virtually all of the cash income from the pass-through companies is also reported in Part III on the Schedule K-1.

The taxable income reported at Line 1 on Part III for a Subchapter S corporation flows to Part II on Schedule E. The Section 179 Deduction at Line 11 also flows to Part II on Schedule E and is used to reduce the Line 1 taxable income. However, the sum of the two amounts are non-cash to the taxpayer since the taxpayer must report his or her share of the company's taxable income and pay the tax obligation on it. The cash to do so is again "passed through" from the taxpayer's company to the taxpayer in the form of cash distributions.

In constructing a personal cash flow statement, only a few pieces of Part III information are relevant:

• Cash distributions reported at Line 16D and cash loan repayments from the company to the taxpayer at Line 16E for a Subchapter S corporation.
• Cash guaranteed payments to partners reported at Line 4c and cash distributions reported at Line 19A for partnerships and LLCs.

No other amounts reported in Part III provide cash income to the owner or partner.

The Section 179 Deduction plays no role in the construction of a personal cash flow statement. Its sole purpose is to reduce the taxpayer's taxable income from the pass-through that he or she owns in whole or in part. The taxable income in question, reduced or not, is a non-cash event for the taxpayer.

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In a recent New York Times article, Peter Coy reports on birthrate research conducted by James Pomeroy, an economist at HSBC in London.

The fall in birthrates in 2023 was even more dramatic than it has been in the recent past, especially since the onset of the COVID pandemic. In fact, only four countries experienced positive birthrates in 2023 according to Pomeroy - the Philippines, Thailand, Malaysia, and Norway. Denmark and the U.S. had the smallest reductions in the birthrate at a negative 1.9%. China was in the middle at a negative birthrate of 5.6%. At the bottom of the list were the Czech Republic, Poland, and Ireland with birthrate decreases of 10% or more.

The problem with declining birthrates is perhaps best illustrated by South Korea's experience. The decline has become a national emergency since, if it continues, the country's population could decrease by two-thirds over the rest of the century. Presently, such concern is leading to closure of nursery schools, expanded baby bonuses, and the possibility of drafting women into the armed forces to meet necessary staffing levels.

A shrinking population is difficult to reverse. Fewer births in one generation lead to fewer child bearing women in the subsequent generation. Fewer people in the labor force become compelled to support an aging population, and life expectancy in most countries continues to increase with better diet and the use of continuous advances in medical technology.

Pomeroy offers four possible solutions to the birthrate issue:

• Raise taxes to assure proper support of an aging population by fewer wage earners.
• Raise the retirement age to keep wage earners active longer with reduced demands on retirement programs.
• Reduce retirement and health care benefits.
• Increase immigration to offset the drop in births.

The U.S. has managed to increase its population slightly in spite of a declining birthrate by increasing immigration. Yet the toxic domestic politics surrounding possible fixes to the immigration crisis at the border hardly suggest the U.S. will choose this option to assure continued growth in its population. Perhaps one or more of the other three options suggested by Pomeroy will turn out to be sufficiently acceptable.

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On February 7th, Shockproof! Training conducts the first session of Commercial Business Underwriting, an eight session Credit College Course designed for analysts and lenders interested in exploring and mastering the analytical tools essential in identifying and assessing a commercial borrower's prospects for meeting its interest-bearing debt service.

The Course is conducted sequentially over eight weeks in live sessions that run between 90 minutes and two hours. The sessions include numerous online questions offered during each session to reinforce key issues and conclusions. The sessions include a Chat function, as well, that allows participants to raise questions throughout the session and interact with the instructor.

At the end of eight sessions, participants will understand how to:

• Sort through and analyze company background information and financial statements.
• Assess management and the competitive environment in which it operates.
• Project likely financial performance, identify sources of cash to meet debt service, and identify risks to those cash sources.
• Shape covenants to mitigate the risks.
• Present conclusions and recommendations in a generic credit write-up format.

If you would like more information about Commercial Business Underwriting, or about any of our other five Credit College Courses, or about our 27 single-topic Webinars, please call us at 1-866-237-7228 or send us an email at inquiry@shockproof.com.

Please note that all single topic Webinars and each session in the Credit College Courses are recorded and available for use and review, should participants prefer the flexibility of on-demand sessions and webinars.

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