Ask Linda Archive


% Ownership: Conflict between K-1 and Operating Agreement

Your question:

When would the % capital ownership on a partnership/LLC k-1 be different than the agreed upon amount in their operating agreement?

Linda says:

You have two choices. Choice # 1: The tax return was prepared incorrectly. Sad, but true that not every preparer gets it right every time.

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Tax Return Analysis: Using Qualified Dividends for Cashflow


Your question:

I was wondering why the Qualified Dividends (9b) on the personal tax returns are not included in tax analysis cash flow.

Linda says:

With the challenge of qualifying borrowers we want to find and include every source of recurring cashflow possible. Add to that, we add Line 8a Tax-exempt Interest so it is natural to assume we could also add Line 9a Qualified Dividends.

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Do I include Foreign Source Income in Tax Return Cash Flow?


Your question:

We have a prospect for a loan that we will broker. Per the lender, this couple live in another country, both work for foreign companies and both receive wages from these various foreign companies. The borrower provided Form 1116 that shows gross income from all sources of $96K in 2009 and $299K in 2010. Should we be giving the borrower credit for this foreign income earned?

Linda says:

Just because the $299K is listed on the Form 1116 does not mean it is foreign source income. Here is how it works.

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The Allowance for Loan and Lease Losses: What should a Director know?


Director question:

The Allowance for Loan and Lease Losses gets a lot of attention. What is appropriate for a director to understand?

Linda says:

When you read the guidance about a director's responsibility for the ALLL, it can be downright scary!

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Fair Market, Liquidation or Book Value on the Balance Sheets


Lender question:

Do you use historical costs or fair market value in a partnership's balance sheet?

Linda says:

That word 'value' gets in the way in accounting. There is Fair Market Value, Liquidation Value and Book Value. Then there is historical cost. Which is used when?

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Valuation of business on owner's balance sheet

Lender question:

For privately held companies, how should lenders consider valuation of the business by owners on their personal balance sheets? These dollars clearly will impact level of leverage, both on a personal basis as well as global.

Linda says:

The amount an individual reports on their personal balance sheet for their owner share in a business can be anything from the actual share of business capital per GAAP statements to a 'fair market value' estimate based on their own sense of what it is worth.

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Five things to do with excess capital at your Bank or Credit Union

Your question:

What do you do with excess capitalization? This question was asked by a Financial Institution Director after my session on 'Finance 2.0 for Directors: Beyond Check-the-Box to Good Governance' at their Association Conference.

Linda says:

Great question! And first, let me congratulate you that you have excess capital on hand. Many financial institutions wish they were in your shoes.

Actually, many financial institutions are in your shoes and have the same question...when can we let go of the extra cushion we created during the recession.

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How does loan source impact where/how interest is deducted?

Your question:

I have a borrower who has a HELOC on their primary residence that they used to pay off their mortgage on their rental. On their schedule E, they have written off the interest on the rental (even though the subject property on the loan is their primary residence). Is this allowed? On line 40 of their 1040, they took the standard deduction of $11,400.

Linda says:

You have stumbled on an area where there are different points of view. On the one hand, IRS Publication 535 on Business Expenses says:

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Do you count shareholder loan activity as cashflow?

Your question:

How should loans to S Corp shareholder(s) be looked at in underwriting a loan? Income? Debt? In a negative way?

Linda says:

Great question and one we often don't consider. My standard cashflow worksheet does not include a place to indicate loans made to shareholders in the same way it has a place to enter shareholder distributions, for example. And I have trained banks all over the country with standard and proprietary software and do not see this routinely considered.

But it makes sense that we should consider it since borrowing from their company is one of the ways an S-Corp shareholder can take money out of the company. Others are wages, rent if s/he owns the building, and distributions of capital.

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GAAP vs Tax Basis Accounting

Your question:

What are the substantial differences between GAAP accounting and income tax basis accounting? Is income tax basis accounting synonymous with cash basis? We see a lot of statements compiled or reviewed on an income tax basis and I am wondering what we are missing.

Linda says:

Wouldn't it be great if we just pick something and stick with it? Nah, that would be too easy. Actually, it just wouldn't fit the needs of business.

Income tax basis is considered an OCBA (Other Comprehensive Basis of Accounting) and is very common fo small- to medium- size business.

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Treat Section 179 expense same as depreciation?

Your question:

Several of our analysts believe that 179 deductions should be treated like depreciation because it is an election to take the expense rather than capitalize the expenditure and depreciate the asset over time. I disagree and believe that adding it back may overstate cash-flow. What do you think?

Linda says:

You have stumbled across the weakness in adding back ANY depreciation...that even though depreciation does not represent an outlay of cash, they DO pay for the equipment, vehicles and the like. It takes cash out flow at some point.

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What can I count for Note/Contract receivable?

Your question:

Regarding Notes Receivable and Form 6252: I understand my borrowers are reporting the interest they received from the note receivable on Schedule B and the principal portion is reported on 6252. My question is what line of 6252 do I use? All of my reference materials say to use line 25. On line 21 there is a figure that I believe to be the full principal amount received, but should I be using line 24 which has had the gross profit percentage from line 19 factored in?

Linda says:

You guessed right, the correct line for principal received is Line 21 of the Form 6252. That is the principal received in the prior year. CAUTION: You want to use the full principal, not just the taxable part, because we are looking for cashflow, not taxable income.

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How to use Sch A Itemized Deductions in Cashflow

Your question:

What is your take on deducting the expenses noted on the Schedule A like charitable donations, job related expenses, and medical expenses from the net cash flow? I know every bank looks at things a bit different.

Linda says:

You are right, banks look at this differently. Here is my take.

Let's say you use a debt-to-income ratio for personal lending or guarantor analysis of 40%. That means the other 60% is left over for family living expenses, paying taxes and savings.

Many would say that charitable contributions and medical expenses are part of family living expenses. And in the case of charitable contributions, are optional. I would tend to agree with them.

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Does Schedule D 'cost basis' include current debt obligations?

Your question:

Does the "cost basis" on the Schedule D include any of current debt obligations associated with the Real Estate sold? Can you please clarify why you would need to obtain a closing statment due to seller.

Linda says:

Great question. Capital gains is an area that is often a challenge.

The cost or basis is related to what the borrower paid for the properties plus any significant capital improvements. It has absolutely nothing to do with the amount the borrower owes on the property.

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Non-Profits: Forms and Cashflow

Your question:

Do nonprofit organizations still need to file tax returns even if they don't pay taxes? Don't they file to keep their nonprofit organization status?

Linda says:

The form you are looking for is Form 990 Return of Organization Exempt from Income Tax. I have inserted Page One below.

You need to know who must file, how to cashflow the form and what else to ask.

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How does debt forgiveness impact taxable income? Cashflow?

Your question:

I have heard that borrowers have to pay taxes on the debt forgiven in a foreclosure or debt restructure.

  • Is that true?
  • Where do I find it on the tax return?
  • Should I count it in cashflow calculations?

Linda says:

In some cases the borrower will pay taxes on the debt forgiven. The IRS treats it like a sale. There are variations as to whether the borrower has to pay, how the 'income' is treated (capital gain or ordinary income) and where you will find it.

A general understanding of borrower options will help you estimate the real impact of a restructure or foreclosure both on cashflow and the borrower's ability to pay the newly restructured debt.

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Can I add qualified dividends?

Your question:

I know I can add tax-exempt interest on the 1040 Line 8b in addition to the taxable interest on Line 8a. Is that true for the qualified dividends on Line 9b?

Linda says:

You are right about the interest. The only caveat is that tax-exempt interest on Line 8b could include pass-through from a k-1. If it does, you are likely to run into k-1 pass-through elsewhere in the tax return. When you get the k-1, you can spot the tax-exempt pass-through.

I am sorry to say that the same cannot be said for qualified dividends.

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If YTD Financial Statement shows improvement can I use it in qualifying cashflow?

Your question:

Can I safely use year-to-date financial statements in my analysis?

We get the year-to-date financial statements in addition to the most recent two years tax returns. If I average the two-years tax returns, the borrower does not qualify. But if I factor in the year-to-date financial statements, the borrower does qualify.

Linda says:

In a previous question on how to qualify borrowers as historical information get's worse I gave a few suggestions for using year-to-date financial statements.

As to your specific question about including YTD financial statement info in your averages, you need to check your guidelines. Even if guidelines do not allow that calculation, YTD financial statements help tell the story.

If you absolutely need the year-to-date numbers to qualify your borrower or if your judgment about the credit-worthiness of the borrower is heavily influenced by those statements, here are some additional ideas.

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How do I qualify borrowers as historical data gets worse instead of better?

Your question:

I have heard you say that business lending will be harder in the recovery, not easier. What is going to make it harder and what specific additional steps do lenders need to take to get the borrowers qualified?

Linda says:

Here is the challenge...as we move into the recovery you are still using historical data to project recurring cashflow available to pay debt. But as time moves on, the newer year's history is going to be from the worst of the recession and you are dropping off the older year's which were before the recession.
 
Perhaps you have been using 2005, 2006 and 2007. When you can get the extended 2008 returns, you'll drop off 2005. Even worse, if you only use two year's tax returns, you are dropping off 2005 and 2006 and you are left with 2007 and 2008.
 
Many businesses had some rough years starting in 2007 and certainly going through 2008. By the time you get their 2009 year-to-date financials it may not be a pretty picture.

And it may not be a very accurate picture of how their business will do as the economy improves. You are losing the historical evidence of profitability just when the business borrower needs to gear up for the recovery and borrow more.

Here are some specific suggestions...

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Add back LIFO Reserve?

Your question:

I am working on a traditional cash flow for a car dealership (net income + depreciation + interest) based off of corporate tax return information. They use the LIFO method to value inventory. The accountant is telling me that I need to add the "LIFO Reserve" figure back to the traditional cash flow to get a correct cash flow. Can you give me some details on the LIFO reserve and why it is/isn't correct to add it back?

Linda says:

Quick definitions:

  • FIFO: First-in-first-out inventory method assuming inventory sold is the first inventory purchased or manufactured.
  • LIFO: Last-in-first-out inventory method assuming inventory sold is the most recent purchased or manufactured.
  • LIFO Reserves: The difference between inventory based on the FIFO method and LIFO method from the day the company started using LIFO.
I do not agree with your borrower's accountant....

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COGS: Impact of Negative 263A costs

Your question:

Would you include negative section 263A deductions to a manufacturing company's cash flow?

Linda says:

Short answer: I would not make an adjustment for this.

Longer answer: Section 263a costs are part of Cost of Goods Sold and, when positive, are a required allocation of some of the costs that might normally be recorded on page one of the return but are indirectly related to inventory. Generally, they include:

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Cash from a trust: Revocable or Irrevocable?

Your question:

Will I be able to get a k-1 from a trust to show the cash distributed to the borrower?

Linda says:

Maybe...and no. Don't you hate that answer? Maybe to the ability to get the k-1; It depends on whether the trust is revocable or irrevocable. No to the k-1 showing cash distributed.

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Resources to help RE brokers and agents?

Your question:

Our real estate market is just showing signs of turning around. Have you found resources I can provide to the brokers and agents who are also my borrowers?

Linda says:

I have found resources for industries that really are struggling. The businesses left standing will have some incredible opportunities coming up. To find the real estate expert, I did not have to look far. I have known Carla Cross, CRB for 20 years. She is well known in real estate, has appeared on CNN, MSNBC, dozens of radio programs, and has written hundreds of articles for newspapers, newsletters, and real estate magazines.

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Construction lenders: Resources to help contractors?

Your question:

Can you recommend resources to help construction borrowers besides modifying their loans?

Linda says:

I have been looking for resources for challenged industries so you can be a hero! I found George Hedley, CSP. In 1977, starting with an old Datsun pickup truck and $500 in the bank, George was able to build a thriving $50 million construction business in just seven years. He has built a reputation for helping entrepreneurs and contractors build business that work.

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Why subtract 50% meals & entertainment

Your question:

Some lenders in my office don't subtract the 50% meals and entertainment because they figure the owner/employees have to eat anyway. Is this a judgment call? It can be a significant amount for our higher income borrowers.

Linda says:

Two responses:
1) Check your guidelines.
2) Understand what is in 'meals and entertainment' (and the risk of ignoring the 50% out-of-pocket nondeducted cash outlay).

In the last year, I saw a 1040 Schedule C with $63,000 nondeducted meals and entertainment. Is that an outlay you'd want to ignore?

Half of what is spent on meals and entertainment is deductible. It follows that the other half is not. Meals are deductible if the borrower is traveling or if the meal is business related.

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Impact of economy on Relationship Banking

Your Question:

Three part question:

  1. What should we be looking for to determine if our business borrowers are taking necessary steps to weather the storm or are burying their head in the sand?
  2. How can I be a resource and what might I suggest in conversation?
  3. How does all of this impact my focus on relationships instead of transactions?

Linda says:

In normal times, the 'Special Assets' team digs deeper to see what can be done by a business in trouble. In this 'all hands on deck' economic environment, understanding the steps your business borrower can take to weather the storm will benefit every business lender. You'll spot problems more quickly and can be a resource with ideas that can help your borrower.

In a recent AICPA WebCast 'Braving the Economic Crisis', aimed at CPA/CFOs, three CPA/CFOs provide insights1. One of them is also on the board of directors of a bank.

Feel free to browse the main points. I have included more detail in case you want to dig in. If you like, you can cut and paste this into a letter out to your business borrowers to let them know you are thinking of them.

CFOs need to:

1. LEAD: One of the most important functions for a CFO in this environment is to ease the collective psyche of their organization, accept the uncertainty and remain calm. (Probably a good idea in your bank, too).

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Form 1045 Tentative Refund for Cashflow?

Your question:

I received a Form 1045 "Application for Tentative Refund" 2007 form, decreasing tax year ended 2005. The client is reducing the amount owed from $444,062 to $17,077. I put this as a negative on federal taxes in the 2007 cashflow analysis. Should I do any more than this? Are there important questions I should ask?

Linda says:

We use the Form 1045 Application for Tentative Refund to carry back a few things. You are probably familiar with the idea of carryovers or carryforwards. Net Operating Losses are often carried forward (Line 21 of a 1040) and are one of the major noncash items we look for. Some types of losses can be carried back first, to get an immediate refund of past taxes paid. The Form 1045 is used in that case.

It has always been true that the NOL reduces federal taxes in the year it is carried to, whether that is forward or back. Here is what I need to know to advise you.

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How can I help my business borrowers?

Your question:

As retail drops off and real estate market challenges impact our local area, what can I do to proactively help my business borrowers?

Linda says:

Be sure your analysis skills are up to speed and you are communicating the work you have done to consider the risk in your loan write-ups. Of course that's essential. Here are some additional ideas to be of service to your business borrowers.

Maybe this would be a good time to take a page from the CPAs...

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Trust Income.... is it cash?

Your question:

My borrower/guarantor has trust income listed on 1040 Schedule E, page two. Are they actually receiving this amount? Will the 1041 K-1 confirm the actual distributions?

Linda says:

K-1s are not the same from the various tax returns:

  • The 1065 K-1 shows actual distributions, and even whether they are cash or 'property'.
  • The 1120S K-1 shows distributions, but does not distinguish between cash or property.
  • The 1041 K-1 shows the amount the beneficiary must report and pay taxes on. It does not specify that the income was actually distributed.
Trusts are complicated and I recommend you seek the input of a senior lender if you are not sure what to request from the borrower. In this 'answer', I cover a few items from the IRS website instructions for 'Form 1041 U.S. Income Tax Return for Estates and Trusts' along with what lenders in a recent training said they ask for.

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Commercial LOC, what to count for debt?

Your question:

When my borrower has a commercial line of credit, I am confused as to what interest we can add back and what interest we need to subtract and WHY?

Linda says:

Most commercial lenders add back interest and put the annual debt service on a debt list for calculation of the debt coverage ratio. Consumer or mortgage lenders, or even a commercial lender calculating excess business cashflow available to (or shortfall needed from) an owner/guarantor, will add back interest and subtract the debt from business cashflow.

Either way, we need to figure out the debt amount for the year. For term debt, that is an easy call; monthly payments times 12. But what if a business has access to a $750,000 commercial line of credit?

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Pass-through Section 1231 income?

Your question:

I am working on a loan the business is a farm (berries). I am looking at his partnership returns and at Schedule K Line 10 Other Income of $69,544. This amount is shown on Form 4797 Sale of Business Property as total gains. This amount does not show on the 1040. Can I use the $69,544?

Linda says:

At the business level, this is taxable gain not shown on page one of the 1065. Check the 4797 for the current year and past year to see if you think it is recurring. Also consider if you need to determine the cashflow or if it is okay to use the gain amount.

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How much is a business worth?

Your question:

Is there a 'rule of thumb' number to use when someone is buying a business? I've heard of % revenue, is there a standard amount or other indicator of a fair price? I am looking at the purchase of a 'pub/eatery' that has gross revenue of $830,000, gross income of $440,000 and a sales price of $500,000 with no real estate.

Linda says:

As to business valuations for sale, there are general rules by type of business, but no overall rule that I am aware of that fits every type of business.

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Form 4797 gain in cashflow?

Your question:

I would like to better understand Form 4797. I am looking at a 2006 tax return and it has $150,000 for Line 6 "Gain from Line 32, from other than casualty or theft".

I flip the page to Part III of Form 4797 and see that my borrower sold an apartment building for a gain of $150,000. Should I include this income? My gut says yes. My borrower's business is real estate, so I would say this practice will happen more than once.

Linda says:

If you have my 1040 manual, you'll find the discussion about Schedule D (2006 page 2-30 through 2-35) helpful. Whether reported on a Schedule D or a Form 4797, gain/loss from a real estate transaction is just that, *taxable* gain or loss.

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Audited, Reviewed or Compiled...difference?

Your question:

I understand company financial statements are often reviewed or compiled. We generally ask for compiled. But there are also unaudited, unqualified and audited. Please explain their hierarchy and all their subtle differences. Can one or more be used in place of compiled?

Linda says:

There are three basic choices and subsets within them.

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'Self-employment earnings' from 1065 K-1

Your question:

Can I use the 'Self-employment earnings (loss)' on Line 14 (A) of the 1065 K-1 as cashflow?

Linda says:

Wouldn't that be great!?! However, if you do, you are likely double-counting income/cashflow.

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Asking questions without offending borrowers

Your question:

With our emphasis on retaining and building lending relationships, how can I frame my questions so I don't offend our long-time borrowers?

Linda says:

Every loan request is an opportunity to create, retain or lose a valuable lending relationship. The questions you ask and the way that you ask them, may determine which you accomplish.

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Capital gains income...use it or not?

Your question:

Should we ever use capital gains income? My senior lender says we do not underwrite based on conversion of assets, only on income.

Linda says:

I had the opportunity recently to witness a fairly heated debate between the President of a Bank and the Loan Review Team from the holding company. Yes, voices were raised and neither side was backing down.

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Skipping documentation

Your question:

Do I have to ask about and get documentation for cashflow that I do not need to qualify my borrower?

Linda says:

Another way to ask this question is "When is enough, enough?"

When you have enough to qualify with wages, business income and the usual sources do you have to get info on alimony, capital gains, notes receivable and the like?

It depends. (Don't you just hate that answer????)

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'Nominee' income

Your question:

What is 'Nominee' income and how do I treat it?

Linda says:

Ignore the expense and the associated income.

Whenever a person gets reported income that is really not theirs, they can report it on their tax return as nominee income. This happens more often in the interest income section. For example, your mother has a savings account and you she adds you to it. The bank accidentally puts you as the primary and sends you the 1099 for your mother's interest income.

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How long can a business show a loss?

Your question:

How long can a business show a loss? Aren't there some rules about hobby losses?

Linda says:

You have seen it...a business that really looks like a hobby, or a tax dodge. When is a business really a business even if running losses? And can we ever safely ignore a business loss?

A simple, general rule is that if the business makes a profit in 3 of 5 years there will be a presumption of profit motive. For horse-racing, it is 2 of 7 years. Don't you wonder what lawmaker owned horses?

For a company that does not meet the presumption of profit motive, the IRS takes a closer look.

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Financial Statements vs Tax Returns

Your question:

Why are tax returns and financial statements for the same year sometimes so different?

Linda says:

There are legitimate differences between tax return and financial statement presentation of the same underlying facts.

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Pass-through income from a Schedule K-1

Your question:

I can understand why a taxpayer wants to show pass-through losses. But why would they show income?

Linda says:

A lender recently asked why the borrower would report a POSITIVE figure from a pass-through, which would require they pay more taxes. The prior two years they had passed through losses on their 1040 Schedule E. Her query ended with the note: "I am not quite sure about the Sch E Pass-Throughs, could you shed some light???"

It's time to open up that Partnership/Corporation manual and read the first couple of pages in the Partnership and S Corporation sections. Owners of pass-through entities (partnerships, LLCs, SCorporations) must include in their personal return on Schedule E their share of the taxable income or loss...whichever it is.

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