Q: Why pull cash out for distributions to stockholders if it means running out of operating cash flow?
A: Distributions are the means by which a pass-through company provides cash to its owners to pay the income obligation on the company’s taxable income. Recall that the owners of a pass-through company, and not the company itself, are responsible for paying the income tax obligation on taxable company income.
If a profitable pass-through company is short of cash and cannot provide distributions to owners in an amount sufficient to meet at least their income tax obligation on taxable company income, the owner or owners must then use their personal cash resources to pay the personal income tax obligation on taxable company income, an event they obviously wish to avoid if at all possible.
If the company can borrow to provide distributions when it is short of cash, it will invariably do so because of pressure from the owners, one or more of whom may be part of company management. In addition, the company, its owners, and its management may attribute the cash shortage to events other than distributions, such as a necessary build up in inventory or a slow down in collecting receivables.
Borrowing under such circumstances may also reflect the attraction for the owners of receiving tax-free income in the form of distributions. Unless distributions exceed an owner’s basis – basically his or her net worth in the company – they are not reported as taxable revenue on Form 1040. As a result, owners of this mindset seek to stretch the amount of the tax-free distribution for their personal benefit regardless of the impact on company cash flow.
The question is a very appropriate because it highlights the need to identify the borrowing cause correctly and completely. Frequently, the cash impact of distributions is overlooked in the analytical process, especially if the lender does not use the UCA cash flow statement to identify borrowing causes.
Course overview: The Five Cs of Credit