Business Lending


This post is generalized from an agblog, Farm CPA Today, by Paul Neiffer. Paul is a CPA with an ag background and serving the agricultural community in central Washington.

While his post is titled "Are You Ready for the Super Bowl of Farming?" the suggestions he makes to farmers to be sure their businesses are play-off ready could apply to many types of businesses.

So consider this checklist of 'best practices' for any business and see how your business clients measure up. I have put in {brackets} the places to substitute the appropriate wording or practices for the type of business you lend to.

As a manager of your {farm operation} are you:

  • Using accrual accounting to determine your true {net farm} income for each year
  • Taking advantage of {precision farming} to minimize your input costs and maximize your revenues
  • Using a marketing plan each year for each {crop}
  • Maximizing your equipment utilization to reduce your overall equipment cost {per acre}
  • Providing appropriate incentives for your employees
  • Taking advantage of a Web Site to provide information to your landlords, employees and other interested parties
  • Being proactive with you banker by providing information before they ask and keeping them updated
  • Obtaining education each year on how to improve each of the above items.

If you are an ag lender, take a look at Paul's blog. Understanding the business and tax side of agriculture will improve your lending knowledge-base.

What blogs or online resources do you use to keep abreast of business and business lending issues?

Lenders and underwriters in my training workshops on Cashflow Analysis of Tax Returns often stumble a bit on that word 'guaranteed'. After all, we all know what that means, right?

Well, it is dangerous to assume that words on tax returns or in financial statements mean the same thing the do in common usage. Read on and at the bottom of this post I'll tell you what 'guaranteed' means in IRSSpeak.

Where do you find guaranteed payments?

Guaranteed Payments show up on:

  1. Form 1065 Page One
  2. Form 1065 Schedule K
  3. Form 1065 Schedule K-1 (for each owner who receives them)
  4. Form 1040 Schedule E (although it is buried in the taxable amount listed for the partnership or LLC)

What are guaranteed payments?

Owners of partnership (partners) and LLCs (members) do not get paid wages. Their 'pay' is in the form of capital distributions which are based on % ownership...most of the time.

But what if my % ownership does not reflect the value of my contribution in terms of time, expertise or some other critical factor? Should I really split our 'profits' 50/50 just because I am a 50% owner, when I am the one who puts in the time or brings the expertise to the table to land the business?

Guaranteed payments are the way we can make distributions to the owners that are not related to the agreed-upon profit and loss split.

How guaranteed payments work

Here are some examples:

  1. I own 25% of my LLC. The other owner owns 75%. We have an agreement that whichever one of us brings in a new client receives a 'finder fee' of 1% of first-year revenues from that client. Those payments will be made as guaranteed payments.
  2. I own 50% of my partnership. I work full time in the business and the other 50% owner does not work for the business. We have an agreement that I get paid $20 per hour for each hour worked. Then we split the profits 50/50.
  3. I own 75% of my partnership. I recruit a second partner who has an incredible reputation in the business. He does not work in the business but is an avid blogger and speaks at industry conferences. We have an agreement that he gets a $1,000 bonus for every referral that turns into a client.

What do you as a lender/underwriter do with guaranteed payments?

  1. Form 1065 Page One: Nothing if you have already included them in taxable income either by starting with the bottom line of the return, with net income from Schedule M-1 or by subtracting total expenses on page one. Or include guaranteed payments just as you include other expenses if you are entering each type of expense on your spreadsheet.
  2. Form 1065 Schedule K: Nothing
  3. Form 1065 Schedule K-1 (for each owner who receives them): Include the Guaranteed Payments (Line 4 or 5 depending on which year return you are reviewing) in personal, historical cashflow
  4. Form 1040 Schedule E (although it is buried in the taxable amount listed for the partnership or LLC: Do not use this number. It is a placeholder for the number you actually need, which is either historical personal cashflow or cashflow available from the company.

CAUTION!!!

If you are not in the habit of checking for guaranteed payments on a 1065 K-1 when you are calculating actual historical cashflow you run the risk of missing a significant, recurring source of cashflow.

IRS definition of 'guaranteed':

When it comes to guaranteed payments, this refers to the fact that these payments are guaranteed by an agreement between the partners that is unrelated to the agreement for the profit/loss split.

Just don't look at Schedule K-1, Guaranteed Payments...breathe a sigh of relief...and say to yourself: "Well, at least they are guaranteed income from this company."

Really? Can you do that?

Check your Guidelines

Well, first, consider that a lender/underwriter can do whatever the financial institution's (FI) guidelines allow assuming they are consistently applied in a legal manner. So if your FI allows you to use asset conversion, you can.

What is the difference?

Asset Conversion

You are counting on the borrower to liquidate assets to service the debt.

Income

You are counting on the borrower to generate income from earnings (or operations if a business) to service the debt.

Is there a preference?

Most lenders prefer to lend on income from earnings (or operations if a business) rather than counting on the prospective borrower to liquidate assets (asset conversion) to make their debt payments on a timely basis.

Wait just a minute!

There are groups of borrowers who absolutely count on asset conversion to service debt, with the blessings of their lenders. This includes retired people for whom, if they did it right, their asset conversion is now their primary source of income. Drawing from IRAs and Pensions is asset conversion. Selling off an accumulated stock portfolio or real estate is asset conversion.

Borrowers who are real estate investors, especially if they have done okay during the recession, are buying (and sometimes rehabbing) and then selling real estate. I know we are all leery of the 'flippers' but some of them did just fine.

My advice:

Consider whether the income from asset conversion is sustainable given the borrowers networth and access to readily converted assets. Your guidelines may allow you to use this in borrower projected cashflow. If not, it may at least be a significant compensating factor.

Do you use asset conversion as cashflow? If so, when and how?

I live at sea level but only two hours from Mt. Rainier. We had a very late summer this year, some would say we missed it altogether in the Northwest.

But Friday was a summer day. Warm but breezy. Lots of sun. And late August is a great time to visit Mt. Rainier as the wildflowers pop in profusion.

Right? Not quite.

A late summer at sea level, it turns out, means a late summer on the mountain. The wild flowers are not out yet. And on the Skyline Trail, you cannot even get past Myrtle Falls without traversing some snow.

Don't assume...

If you were to go to the Rainier National Park website to check on trail conditions before heading up to the mountain with athletic shoes instead of climbing boots, and without your climbing poles -- I can't imagine who would do that -- here is what you'd find:

August 17, 2011: Mt. Rainier received a heavy amount of spring snow this year creating hazardous conditions in the backcountry. Subsequently we expect a very late melt-out this summer. Issues to consider are route-finding, creek and river crossings and trail damage. Good navigation skills are needed in these conditions. It is easy to get disoriented and/or lost. There are also steep, icy slopes in numerous locations around the park. Always check with Park Rangers for trail conditions before heading out into the backcountry.

Rather than the anticipated 3 hour hike, with a 1,700 foot elevation gain, we headed up one way, turned back due to snow, tried another, turned back. It was still breathtaking but not what we expected.

And if we plan to see the wildflowers, we need to head back up in a few weeks. I'll check online to see if they have popped before I drive the two hours each way to see them!

Lenders: What assumptions are you making about your borrowers?

About how their business is doing because:

  • it is 'Back-to-School' season
  • the recession is over
  • your other borrower's business is improving

Directors: What assumptions are you making about your financial institution?

About how you are doing because:

  • management is upbeat
  • the recession is over
  • the other directors don't seem as concerned

Check your assumptions by checking in...

For lenders and business bankers, not only is it a great time to visit business borrowers to be sure you have a good sense of how business is going, but it is essential because other business bankers looking to increase market share or re-balance their loan portfolio might just get there first.

And if you are a director? Never stop asking those substantive questions to continue monitoring the health of your financial institution.

What is good enough?

One last thought. Just because conditions are less than what you expect doesn't mean they are not good enough. We had a fantastic day. Be open to what you'll find when you ask the questions you should ask. And then make a fresh assessment of the situation.


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.
This article,The Allowance for Loan and Lease Loss Becomes a Heavier Burden for Credit Unions, includes my thoughts on one of the up-and-coming challenges for credit unions and banks in keeping up with the time necessary to review loans for impairment to calculate ALLL accurately at the same time that loan volume is (finally) ticking up.

Read the article...

The issues this article touch on are the very same for community banks.

BTW...I have a strategic partnership with the software company, Sageworks, mentioned in the article. They have a new software solution for ALLL and my clients, readers and subscribers get a significant discount. Let me know if you are interested in a demo and I'll get you the discount!
Here is how you end up with Interest from a Schedule K-1 on 1040 Schedule B:

  • Schedule B includes all taxable income.
  • Interest income received by an S Corporation or a 1065-filing entity like an LLC or partnership is passed through and taxed to the owner of the company
  • Thus interest not received by an individual will be listed on Schedule B
This is another example, once again, that taxable income is not necessarily cashflow.

What do you count?

My favorite answer...and if you are a regular reader of my blogs or have attended my training for lenders and underwriters on Tax Return Analysis...you know what is coming! It depends.

My approach

I do not include Schedule K-1 Interest in personal cashflow. The 1040 filer did not receive that cashflow. It does not mean they did not receive ANY cashflow from the company. But if they did, we'll find what they actually received on their K-1.

The K-1 is a schedule of the 1120S or 1065, not the 1040. So you won't have it unless you ask for it.

It still depends

With a lower % owner, of if you only want to consider actual cashflow from the company to the owner/guarantor, obtain the K-1 and cashflow that. Don't know what to use? Time to come to class, take the Business Tax Return Analysis series of nine eCourses at www.LendersOnlineTraining.com, or order the manual.

Okay, you could also do a site-wide search of this site and find the answer. But if you are a lender, underwriter or analyst -- for a bank or credit union or creditor -- and you have that question, you have other important questions that need a more extensive review of tax return analysis.

With a higher % owner who has control over what she takes from the business, you might prefer to use cashflow available from the company instead of what she took the last couple of years. Obtain the full 1120s or 1065, determine company cashflow, and then give her credit for her share. This is where interest income received by the company will come in.

How low is low and how high is high?

Most lenders provide a guideline for determining whether you request only the K-1 or the entire tax return. Residential mortgage lenders often use a 25% threshold. SBA lenders often use a 20% threshold. I've seen as low as 10% and as high as 51%.

Check your guidelines to decide.

Common sense and judgment

Also consider what type of flexibility you are expected to exercise in the area of judgment and common sense. Are your guidelines more 'guide' or more 'lines in the sand'. Even if the borrower owns less than 25%, if you know the underlying company is in trouble should you consider that? I can't tell you the answer but you need to find out.
I just published the latest eCourse at www.LendersOnlineTraining.com. I know that some small business owners sign up for the Lender's courses to see what the lender wants. This would be a good one!

Here is my short list:

  • Cover page...sizzle optional
  • General info including details on source and use of funds
  • Company info including history and management
  • Marketing info including brochures, website screen shots, info on market share and competitors
  • Financial info including projections and recent financials
The eCourse on Loan Proposals can be purchased a la carte or as part of the subscription to the entire eCourse List of over 30 courses. Check out the entire list of online credit courses for lenders.

Clues the lender doesn't want to miss

  • The extent of the business owners marketing and financial knowledge about their business can either give the lender confidence or give her the willies!
  • Typos and grammatical errors in the loan proposal may be an inside window into the sloppy way the company does business with their customers

Surprise!

Here are a few surprises a lender might like to see:

  • Updated loan proposal even if the business lender did not ask
  • Information previously provided has been updated for newer information
  • If financial projections are included, what is the thinking behind it?
  • Independent information that backs the proposal up, such as from the local Economic Development Council
  • An honest and forthright description of recent challenges in the business, actions taken, results and adjustments.

Give 'em a break

If the loan proposal seems overly thick, give the business owner a break. Some lenders take the 'thud factor' (the sheer weight of the proposal) into account so more pages seems the norm these days. Besides, business borrowers may be nervous with what they've heard about the scarcity of business loans. They may think more is better!
Every year I teach Junior Achievement classes in elementary schools. It does not matter how busy I am with 'teaching' business owners and lending professionals. I take time out because it is the right thing to do and I hope you will, too.

It is encouraging!

These kids get it. Sometime between the common sense of a ten year old and the adult years, something gets lost.

Example: The JA book defined a Resource as something people need. One of the students, Max, suggested it should define a Resource as something people need or want. I had to agree!

Planning a business...

The students were given about five minutes to come up with a business they might start:
  • Business name
  • Type of business
  • Good or service
  • Natural resources they might need
  • Human resources they might need
  • Capital resources they might need
They struggled with this assignment, particularly in the short time frame. When time was up I asked if it was hard. Their discouraged faces told the story. Yes, it was hard.

I told them it should be. That starting a business is hard. That there are a lot of questions to ask before they start. But that every business started just the way they started a few minutes ago, with an idea and a start on the questions.

Time for business owners to (re)ask questions...

Perhaps business owners (and maybe their lenders) should ask questions again. The disruption of the recession calls for it.
  • What business are they in?
  • What has changed for their customers and what has remained the same?
  • What resources do they need?
  • Who can help them answer the questions?
Some business owners never asked the questions in the first place. And most of us need to ask them again.

What questions would you add to the list?

One of the LinkedIn Groups I belong to is having a raging debate about whether that first C of Credit, 'Character', can be considered any more. Or should be considered again! (BTW: Connect with me at LinkedIn. My profile is at 'Linda Keith CPA'.)

Small Business Banking Professionals

That is the group. The discussion posed this question:

Banks are digging deeper into the character of their borrowers. How are you or your bank addressing the "character" issue?


Bankers from around the country and from banks big and small have weighed in. The answers are all over the map, too. Here are some samples:

  • We have to get back to character lending
  • We cannot get back to character lending
  • The business bankers don't make the underwriting decisions and the underwriters don't know the borrower, so character as part of the equation is lost
  • Newer lenders don't get the training or the mentoring they used to and don't know how to take character into account
  • Character lending in any form has the potential to be discriminatory in nature
  • Character is indicated when a borrower has been through very tough times recently but continued to pay as agreed, keep on employees and support the community
  • A red flag for character is If the borrower has run up credit cards or consumer loans for toys (boats, fancy cars) without increased net worth to show for it
  • If business has been tough, finding out how they have treated their vendors, suppliers and customers might be a clue to character
  • A quality centralized underwriting team can coach front-line lenders in the questions to ask and how to document answers that will give the underwriters the 'character' clues they can't get first hand
  • If the lenders compensation is based on origination volume, they might not take the character issues seriously that the underwriter won't be able to discern

Wow, as I said, all over the board.

So how about you?

Does character still factor in? And if so, how? And how do you find out about it?