Instructor Blog - Financial Analysis

Q: In a recent newsletter (Business Income Tax Returns Quiz, Statement 6), you state that "Both guaranteed payments and distributions are operating expenses that must be accounted for in identifying bottom line profit". Both are cash outflows from the partnership, but are they actually expenses in that they reduce profits/taxable income? I’ve always understood that guaranteed payments are treated that way, but not distributions.

A: If we follow GAAP and IRS regulations and guidelines, we would not classify distributions as expenses. But this is a tricky area where the accounting profession and the tax authorities can lead lenders astray.

For many partnerships, distributions are the only source of compensation for the partners. Some will supplement distributions with guaranteed payments, but that depends on the partnership and the individual partners in question. If partners receive guaranteed payments, they must personally make all self-employment taxes. The partnership does not withhold any amount from the guaranteed payments, although it is indeed recognized as a tax-deductible expense. In all instances, guaranteed payments or not, distributions to partners provide the cash partners need to pay the personal income tax liability on taxable partnership income that they must report on their personal Form 1040s.

Given IRS regulations, partners are taxed on the taxable income they must report on their personal Form 1040, even though all such taxable income is non-cash to them apart from guaranteed payments, if any. The distributions are not taxable income to partners. Neither do they decrease the partnership's ordinary business income, which flows to the partners' Form 1040. Distributions do reduce retained earnings or partnership capital just as expenses reduce retained earnings or partnership capital. A dollar increase in partnership expenses has the same impact on partnership capital as a dollar increase in distributions. That is, at the end of the day, distributions and expenses have the same impact on partnership capital.

From a lender's perspective it's critical to call a spade a spade even if the accounting profession or the IRS calls it something else. Any expense to compensate owners or partners or any expense used to pay income taxes on taxable business income is an expense, even if it flows to the partners in the form of a cash distributions. Equally important, distributions decrease a business operation's cash available to service its interest-bearing debt. If we overlook distributions, we run the real risk of overestimating a borrower's ability to service its debt.

In this respect, I recall a situation years ago in which a large law firm declared bankruptcy to the lender's utter astonishment. The law firm was organized as a partnership. The lender had disregarded distributions in all its analysis and had focused only on bottom line profits in the conventional sense. But, after the fact, it was obvious that the law firm had been under water for years when distributions where reclassified as an operating expense. It had stayed afloat by increasing reliance on its short-term line of credit, since it was a highly respectable organization and, presumably, required little close attention.