Today I want to review partnership cash flow adjustments (or 1065 forms). The 1065 is much more like a Schedule C income than it is like a corporation. The 1065 is a bit more complex then Schedule C, but it holds many of the same legal characteristics that a sole proprietor would have. Examples include legal liability for things such as law suits and debts, or that if you are a partner you can’t take a w-2 income from the business (IRS “Paying Yourself” Topic Guide). One fact about partnerships most people don’t know is that LLC’s use the Schedule C for single member LLC’s and 1065 tax forms for two or more members in an LLC even though they are “corporations”.
Ok so on to the numbers we need to know in the world of lending. Reminder: we are not talking about calculating the income here but trying to explain the “why and what” of the adjustments! Therefore, after you review the K-1, here is a list of adjustments to your bottom line based on percentage of ownership.
As a reminder, we are assigning these lines to three types of money, Real Money, Non-cash Expense, and One-time Money. If you need a quick refresher or explanation on the three types of adjustments listed please go back and check out part 2 of this series.
All of these lines are – Real Money Earned (+) or Spent (-)
1065 Line 4 Ordinary Income
1065 Line 5 Net Farm Profit
1065 Line 6 Net Gain Form 4797
1065 Line 7 Other Income
The reason you have to adjust for these four lines is they are reserved for income not earned in the normal course of business. Example: I own a cement repair business so my 1065 form is all about my cement business. However lines 4, 5, 6, and 7 are income from other sources outside of my cement business. Therefore, if I want to leave it in my cash flow I have to separately document the income. I need to ask: “has the borrower received it for two years”, and “is it likely it will continue for three years”.
So if the answer is YES and you can document it all… do nothing to the numbers. If the answer is NO (either due to lack of documentation or not meeting history/future requirements) you must SUBTRACT this income from the borrower’s cash flow. On the other hand if the income in these lines is NEGATIVE or a loss you can add back in that loss IF you can document it is NOT likely to continue in the future (that is trickier!!)
1065 Line 16A Depreciation – Noncash Expense
Refers to prorating a tangible asset’s cost over that asset’s life. For example, a bulldozer is used for a number of years before it becomes worn out and must be replaced. The cost of the equipment is spread out over the predicted life of the equipment, with a portion of the cost being expensed each accounting year, it can be added back based on the ownership percentage to the borrower.
1065 Line 17 Depletion – Noncash Expense
Refers to the allocation of the cost of natural resources over time. For example, an oil well has a finite life before all of the oil is pumped out. Therefore, the oil well’s setup costs are spread out over the predicted life of the oil well. Since FNMA/FHLMC understands that a business did not write this check to anyone, it can be added back based on the ownership percentage to the borrower.
1065 Schedule L line 16D – Real Money
This line tends to mess up a lot of loans! If there is a number listed in line 16D you must subtract the percentage of debt from the borrower’s income. What this represents is a short term debt or mortgage. So if the Schedule L shows there is a short term debt or mortgage due this tax year…well you HAVE to pay it! For example if a company only has $50,000 in assets and owes a $100,000 mortgage within one year they are broke (or will go further in debt)! Fear not, there are a few ways you can mitigate this line.
Method A
Document this is a roll over debt or mortgage, some of these debts and mortgages are paid off and renewed on a yearly basis. If you can document the debt is not actually due you don’t have to subtract it from the borrowers income.
Method B
Review the Schedule L and if the company has enough liquid assets to cover the debt, you do not need to subtract this from the borrower’s income.
1065 Schedule M1- Line 4B – Real Money
The IRS allows you to write off 50% of the full amount of receipts turned in for this category. For example if you turn in $1,000 of receipts on line 4B it will show and “expense” of $500. Because FNMA and FHLMC know the IRS only allows 50% you are required to subtract the “other” 50% based on percentage of ownership from the borrower’s income.