Q: I have been told by several prospective Borrowers that the entity is a single owner entity and they do not file tax returns. Is this possible? And if not, how do I analyze the business without its tax return and a Schedule K1 for the sole owner?
A: If the entity is a C Corp, S Corp, partnership, or limited liability company with a single owner, it must file a business income tax return. For a C Corp, the business income tax return states the income tax obligation and the amount of income tax due and payable by the C Corporation. For an S Corp, partnership, or LLC, the business income tax returns identifies for the IRS and the state income tax authorities the amount of taxable income that must be reported on the owner or partner's personal income tax returns. The owner or partner pays the income tax obligation that is passed through to him or her.
If the single owner is a sole proprietor, the company's taxable revenue is reported on the owners' Schedule C, which is part of his or her personal income tax return. Consequently, the sole proprietorship - the business itself - does not file an separate income tax return.
And if this is a Single-member LLC, that represents an LLC in name only but a Schedule C sole proprietorship for income tax purposes.
Q: Since there is a current year loss in rental real estate income, shouldn’t we still adjust the cash flow to show the current year loss? I understand the tax code you explained. However, for cash flow purposes, shouldn’t we show the non-passive ordinary business income, but also show the correct rental RE loss?
A: If you are constructing a cash flow statement for a Schedule C business, then - regardless of profit or loss - back out depreciation expense to get "cash flow". However, if you are constructing a personal cash flow statement, include only distributions from the single owner entity (assuming its not a sole proprietorship) and loans from the business to the owner. All other income reported on a Schedule K-1 and carried to the personal income tax returns is non-cash. Passive or non-passive ordinary business income is not used in constructing a personal cash flow statement. Neither is a rental real estate loss. Only the actual cash flows from the business to the owner are used and included.
Course overview: Understanding Schedules K-1