Q: What are the reasons an owner receives distributions from related party business entities he or she owns?

A: Subchapter S Corporations, Partnerships, and Limited Liability Companies are known as “pass-through companies” because they pass the responsibility for paying taxes on their earnings to the owners or partners. Distributions are part of the regulatory guidance provided by the IRS and do two things:

• They provide tax-free cash to owners or partners to pay income tax on company or partnership taxable income without creating any additional tax consequence.
• To the extent that distributions exceed the amount of taxes due, they provide tax-free cash compensation to owners and partners.

Q: Regulators have questioned the methodology that employs guarantor's cash flow after personal debt service preferring to see total debt service of all related entities (and the guarantor) as it relates to total global cash flow available. What are your thoughts/experiences on the differences?

A: We prefer to employ guarantor cash flow available to support guaranteed debt as the amount available after the guarantor has met its own debt service. We believe this to be appropriate since a guarantor will always meet personal debt service first to maintain his/her position in the community. After he or she has done so, any remaining cash flow is available to support a related party's debt service.

It is important that we recognize that it is the guarantor's readily available cash that matters and not available cash flow. Available cash flow can disappear in times of financial difficulty and even in good times can end up anywhere and not be available to meet a guarantor’s obligations. The proof of the pudding is to identify the amount of available cash flow that ends up as ready cash or other liquid assets available to support guaranteed borrower debt service.

Q: How were 2015 projected distributions for Clovis Supply and Modesto Services computed using the maximum combined California and Federal 51.90% tax rate as cited in the Revised Global Cash Flow worksheet?

A: We computed distributions as 51.90% of projected 2015 net income before deducting the California state franchise tax. Our projection assumptions indicate that 2014 net income will repeat in 2015 as will all associated 2014 expenses. We calculated the taxable 2015 base for both businesses by adding the 2014 Franchise Tax (and any Deferred Tax) back to the reported 2014 Net Income. We then multiplied the result by the assumed combined tax rate of 51.9% to arrive at the amount of projected distribution.   

The before state franchise tax income (equates to Taxable Income on the income statement) for Clovis Supply for 2015 was $255,921. Multiplying the taxable income by the 51.9% rate generates a distribution of $132,823. For Modesto Services, taxable income is $737,376. When multiplied by the 51.9% tax rate, the estimated tax due and the associated distribution is $382,698.

Q: What about the California One-Action Rule?

A: The California Single Action Rule allows a lender to go against property securing a loan or guarantor to collect on a shortfall in event of default, but not both. The simple answer is that a lender will choose to proceed against the source that provides the greatest potential for generating cash in event of default. Of course, this simple answer requires that the lender be fully aware of the value of the collateral property and the overall financial position of the guarantor.