July 2011 Archives



S Corporations

A corporation that decides to be taxed under Sub-chapter S of the Internal Revenue Code is an S-Corporation. The Corporation files an 1120S instead of an 1120.

The big difference between a 'regular' corporation and an S Corporation is that the latter is a pass-through entity. Income, deductions, credits all pass through to the shareholder's return, where it is taxed.

Limited Liability Companies (LLCs)

If an LLC has only one owner, it files as if it was not a separate entity at all. If it is a business it will file on Schedule C or F (Farm) in the owner's 1040. If it is a rental, it will be reported on the 1040 Schedule E, just as if the owner of the LLC owned the rental personally.

If there are two or more owners (called members), an LLC actually chooses how it will file. The return-of-choice in my experience is the Form 1065, the same form filed by partnerships.

Similarities:

Both are pass-through entities. Generally, the owners pay taxes on the income or get the tax shelter of the losses. (You'll see CPAs use the word 'generally' when there are some exceptions. Those exceptions are definitely beyond the scope of this blog post!)

Both provide limited liability. Generally, the owners are not personally liable for business obligations. (Yes, you caught that word generally, right?)

Differences:

Generally, the S Corporation shareholder can take some 'pay' as wages and some as distributions. The federal taxes are not impacted but there are no payroll taxes on shareholder distributions. The IRS will challenge it if the shareholder takes all their 'pay' as distributions just to avoid payroll taxes.

There is more flexibility with an LLC in terms of profit-, loss- and owership-percentage. But the LLC owner, if involved in the business more than just an investor, must pay 'payroll taxes' on all the profits.

Too much information?

If that last section was more than you wanted to know, know this. From your perspective as a lender, there is not a lot of difference.

  • They both have limited liability in most cases, except when they have guaranteed loans.
  • They both have a k-1 to tell you what they actually took home from the business. (With the S Corporation, the k-1 distributions are in addition to wages.)
  • In both cases, if the owner owns a high percentage and you are lending to the business, you'll likely want to include the owner/guarantor in your analysis.
  • In both cases, if the owner owns a high percentage and you are lending to that owner, you'll likely want to include the business in your analysis.

Need more help?

The series at www.LendersOnlineTraining.com on Tax Return Analysis: Business Tax Returns includes 9 eCourses: 3 each on 1120, 1120S and 1065. And the eCourse on Types of Entities can be purchased a la carte or is part of the Financial Statement Analysis set of 9 eCourses. Check them out.

Allowance for Loan and Lease Losses: ALLL

This is often thought of as a reserve, a set-aside for the fact that some borrower is not going to pay. Which borrower? We don't know, otherwise we would not have lent to them.

Going up?

The Allowance increases in one of two ways:

The financial institution recognizes an expense, the Provision for Loan and Lease Losses, to build the Allowance to the 'best guess' required to prepare for loans that will not be collected. This guess is based on a rather complicated, and extensive process of

  • identifying loans that are at risk (impaired) and determining the likely amount that might be received, and
  • applying a historical loss rate, modified for today's environment, to the remaining loans on the books.

Recoveries outpace charge-offs. This is the least painful way to build (or rebuild) the allowance and results when the financial institution recovers previously charged-off loans faster than the decision to charge-off other loans.

This may happen when a recession truly turns the corner into recovery and loans perform better than expected.

The impact of an increasing ALLL

If it goes up as a result of booking the expense, the increase reduces profits and the resulting addition to capital for that period. Shareholders may not be as happy, but examiners and auditors likely will be.

If it goes up as a result of improving recoveries, everyone is likely to be happy.

Either way, if the guess as to the ALLL is a good one, the balance sheet more accurately reflects the loans receivable. Anyone trying to understand how well (or not) the bank or credit union is doing should appreciate that.