Steven Buker, Author at Bukers Taxanalysis

Retained Earnings Adjustment on Schedule M-2

Steven Buker — Wed, 20 Nov 2024 15:19:00 +0000

Retained Earnings on Schedule M-2

We frequently receive questions on the Bukers Hotline about spreading the Schedule M-2 of Form 1120S, specifically regarding retained earnings adjustments. While it can be somewhat uncommon to have retained earnings adjustments on the Schedule M-2, they are important items to be aware of when spreading an S Corporation tax return.

Schedule M-2 Application

When spreading the Schedule M-2 of Form 1120S in Bukers BTA Pro, you will see instructions in red font on Line 3 Other Additions and on Line 5 Other Reductions to only enter amounts that are specifically retained earnings adjustments. The key follow-up question is “how do I know if the additions and reductions on my tax return are retained earnings adjustments?”

To make this determination, you need to analyze the white paper detail for Line 3 and Line 5 of the Schedule M-2. Retained earnings adjustments can be positive or negative and therefore can appear on either Line 3 Other Additions or Line 5 Other Reductions.

On the white paper detail, the retained earnings adjustments can have many different names, but some common descriptions to watch for are “Prior Period Adjustments” and “Changes in Accounting Methods”. These are both items that can positively or negatively affect the retained earnings of the S Corporation, but they are not items of income or expense included in the calculation of taxable income.

Avoiding Pitfalls on Schedule M-2

Please note that most items comprising Lines 3 or 5 of Schedule M-2 will be the separately stated items of income or expense from Schedule K. For example, you’ll commonly see “Interest Income” or “1231 Gains” as additions on Line 3 and “179 Expense” or “Charitable Contributions” as reductions on Line 5. If you are unsure if the item listed in the white paper detail is a retained earnings adjustment, check to see if it is a separately stated item of income or expense listed on the Schedule K. If it is an item listed on Schedule K, then it is not a Retained Earnings Adjustment and would not need to be included in the Schedule M-2 page of your spread in Bukers BTA Pro.

This point is illustrated in the example below, which includes white paper detail related to the Schedule M-2 for Form 1120S. In the example below, the only item we would spread as a retained earnings adjustment would be the AAA Adjustment of $1,332, as everything else represents separately stated items of income and expense from Schedule K.

If you have any further questions regarding this topic, please don’t hesitate to call our Bukers Hotline at (503) 520-1303.

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W-2 Wages and Stock Options: What Lenders Need to Know

Steven Buker — Tue, 01 Oct 2024 08:50:54 +0000

W-2 Wages and Stock Options: What Lenders Need to Know

Have you ever seen the sale of stock on Schedule D with identical purchase and sale dates? At the same time, the sales price is the exact same amount (or close to it) as the cost? This indicates the exercise of stock options by your borrower. As a result, your borrower’s W-2 wages may include “paper” (non-cash) income. It’s important to know how to identify this.

Incentive Stock Options

Companies use stock options to compensate key employees and executives. Incentive stock options (ISOs) are a common form of stock compensation that grant the right to purchase company stock at a discounted price in the future.

When properly executed, ISOs offer significant tax advantages as employees may receive and exercise the ISO without recognizing any gross income. The employee merely records a capital gain when they sell the acquired company stock, which is taxed at a lower rate. Great deal!

However, this preferential tax treatment only applies when an employee meets the specified ISO holding period. When employees do not have patience to hold the stock option for at least two years before exercising, along with meeting additional required criteria, they lose out on the tax benefits. The value of the stock compensation is then included in gross wages on the Form W-2 and taxed at higher ordinary income tax rates.

Incentive Stock Option Example

Let’s say a company grants ISOs worth $10,000 on October 1st to its employee, Sue Barew. Six months later, the company’s stock price soars and Sue really wants to buy a new car. Sue exercises the stock option and sells it on April 1st for $60,000. Sue exercised her ISO too early and does not meet the ISO holding period.

Because Sue did not satisfy the holding period, her Schedule D will report $60,000 for both the sales price and cost of the stock. Her W-2 will then include the actual gain of $50,000 ($60,000 sales price less $10,000 exercise price) in box 1 gross wages. The gain will be included as wages on line 1 of Form 1040 and taxed at higher ordinary income tax rates.

When this occurs, it’s important to not include the gain of $50,000 as W-2 wages for your borrower. This is really “paper” income that’s included as part of salaries on page 1 of Form 1040. Obtaining the W-2 can easily show you how much in salary is actually “paper.” The trigger for identifying this “paper” income in salaries is the specific presentation of the Schedule D as described above. Watch out for this when dealing with executives from companies with stock option plans, especially technology companies.

Want More Detail On This?

The Bukers Academy Online training devotes an entire learning module to this very topic. We’ve included detailed tax return examples to show you exactly what you need to look for on your borrower’s W-2 and tax return to identify actual cash flow from stock compensation.

Curious to see if Bukers Academy Online is a good fit for you and your institution? Please email us at bukers.academy@taxanalysis.com or give us a call at (503) 520-1303.

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Federal Tax Refunds: Should They Be Included in Cash Flow?

Steven Buker — Tue, 10 Sep 2024 10:30:20 +0000

Federal Tax Refunds: Should They Be Included in Cash Flow?

Should the Federal tax refund be included in the cash flow analysis of your borrower’s tax return? This is a question we commonly hear from lenders and analysts. Most individuals receive tax refunds when they file their Form 1040. But, is this something we should actually include in our cash flow calculation?

Federal Tax Refund on Form 1040

The Form 1040 reports the taxpayer’s total tax obligation on line 24. The total tax payments made during the year are totaled on line 33. When the tax payments exceed the taxpayer’s total tax due, the excess is either applied to the next year or refunded directly to the taxpayer, as shown on line 35a.

Cash Flow Impact

While the Federal tax refund is a cash inflow for the taxpayer, this should be disregarded when analyzing your borrower’s tax return in the Bukers Taxanalysis software.

Before arriving at our calculation of cash available for debt service (CAFDS), we capture the total Federal tax obligation for our borrower. We find this amount on line 24 of Form 1040. This represents the total tax owed by the taxpayer for the year based on their taxable income.

The tax payment and refund information is essentially meaningless as it only tells us whether the taxpayer overpaid or underpaid their tax liability during the year. Look at the example above. Let’s imagine that the borrower expected a larger tax obligation and made more estimated payments so their total payments on line 33 totaled $280,000. This would result in an overpayment and potential refund of $200,000. This hypothetical doesn’t change the fact that their total Federal tax obligation is still $80,000 as shown on line 24.

The Bottom Line

Our ultimate objective is to determine our borrower’s cash available for debt service. To account for their Federal taxes, we use their actual tax obligation as shown on line 24. We ignore the payment and refund amounts.

Key Takeaway for Lenders

Federal tax refunds only show us how much the borrower overpaid their estimated taxes. They are merely timing differences, not reliable sources of cash inflow. Instead, we pick up Federal Taxes on Form 1040 line 24 for our analysis.

Note, in calculating recurring cash flow for your borrower, it may be appropriate to adjust the Federal taxes reported on line 24 to account for your borrower’s nonrecurring income or expense. This is a concept we discuss thoroughly in Bukers Academy Online, which teaches the theory and complexities of tax return analysis through an interactive, web-based learning platform.

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Schedule F vs. Form 4835: Key Differences for Lenders

Steven Buker — Tue, 30 Jul 2024 16:21:33 +0000

Schedule F vs. Form 4835: Key Differences for Lenders

Did you know that farming income can either be reported on Schedule F or Form 4835 in your borrower’s tax return? An analyst recently reached out to our experts through the Bukers Hotline asking what the difference is between these two forms.

The difference is important as it tells us about a person’s level of involvement in their farming business.

Form 4835

The Form 4835 is used by the landowner of a farm to report farming income in the following situation:

a landowner of a farm leases their farm to a tenant,

the landowner does not materially participate in the farming activity, and

the landowner receives rental income from the tenant based on the production of crops or livestock.

Form 4835 is used when all three of the above conditions are met. Note, the term “material participation” is a tax term that describes whether a person actively works in the management or operation of a business. There are specific factors that test whether material participation is met.

Schedule F

The Schedule F is generally used to report farming income in all other circumstances. Any person who owns farming property and does not lease out the land will report the farming income on Schedule F. Additionally, any individual who materially participates in their farming activity will use Schedule F.

Note, in the situation where a landowner leases their farm to a tenant and receives a flat rental fee for the pasture or farmland, this income is not farming income. This income is rental income that the landowner will report on their Schedule E.

Cash Flow Implications

As you can see, your borrower’s income from a farm will be reported on either Schedule F or Form 4835. It’s imperative that you capture the farming income from either form for your cash flow analysis. Each form has a similar format, however there are specific line-item differences. The Bukers Taxanalysis software incorporates line-item references to both the Schedule F and the Form 4835, to provide you with a comprehensive tool to analyze any farming income from your borrower.

Note, if your borrower’s tax return includes both Schedule F and Form 4835, each form is reporting different sources of income and you’ll want to make sure you capture both income sources in your cash flow analysis.

Are you interested in seeing how the Bukers Taxanalysis software walks you through the analysis of the Schedule F and Form 4835? Schedule a demonstration today.

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Revocable Living Trust Listed as Partner on a K-1

Steven Buker — Thu, 27 Jun 2024 14:30:37 +0000

Revocable Living Trust Listed as Partner on a K-1

What Does This Mean and How Does This Impact Cash Flow?

An analyst recently called the Bukers Hotline and asked, “I have a partnership K-1 paying sizeable distributions to the partner listed as David Smith Revocable Living Trust. How do I cash flow this with respect to my borrower, David Smith?”

Let’s start first by talking about living trusts. A living trust is an estate planning tool that allows someone, upon their death, to pass assets on to their beneficiaries while avoiding probate. Avoiding probate can save 8% to 11% of the assets by avoiding lawyer fees, court costs, etc.

Living trusts can either be revocable or irrevocable. Let’s focus on our analyst’s question about revocable living trusts first.

Revocable Living Trusts

With a revocable living trust, the trust creator (grantor) maintains control over the assets held by the trust, as well as the income or cash flow that the assets generate. They can easily modify or revoke the trust at any time during their lifetime.

For tax purposes, revocable living trusts are disregarded entities. In other words, while the grantor is living, the living trust is ignored for tax purposes. The owner of the living trust is the recipient of any cash from the trust assets.

In this example, David Smith is the owner and creator of the revocable living trust. He contributed his interest in this partnership to the living trust. But, because of the nature of living trusts, we’ll treat our analysis of David Smith as if he still directly owned the partnership interest. The distributions coming from the partnership go to David directly and should be treated as part of his personal cash flow.

Irrevocable Trusts

An irrevocable trust differs from a revocable trust in that the trust creator relinquishes control over the assets held by the trust and the trust cannot be easily modified. With an irrevocable trust, you would need to ask either the Fiduciary from the trust or the CPA who prepared the trust tax return (Form 1041) as to how much cash was actually distributed.

Conclusion

If you’re interested in more detailed explanations like this, look at Bukers Academy Online. Our new online training platform breaks down advanced topics like this into interactive learning modules designed to teach the advanced concepts necessary to analyze complex tax returns.  

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Different S-Corporation Distributions Reported on Form 1120-S – Which is Correct?

Steven Buker — Tue, 28 May 2024 22:48:59 +0000

Different S Corporation Distributions Reported on Form 1120-S

How to Properly Identify Actual Distributions

Have you ever spread a business tax return for an S corporation and noticed that the Form 1120-S reported multiple different distribution amounts? This may result in an out-of-balance retained earnings reconciliation within your analysis.

It’s imperative that you use the correct value of actual distributions in your analysis.

S Corporation Example with Different Distributions

A senior credit analyst recently called the Bukers Hotline with this situation for an S corporation. The Schedule M-2 reported $50,000 in distributions on line 7 while the Schedule K reported $80,000 in distributions on line 16d. Typically, these two amounts match. In this case, the analyst had no idea which amount reflected the actual distributions paid out by the S corporation.

Schedule M-2 Example

Schedule K Example

Column A of the Schedule M-2 calculates the Accumulated Adjustments Account (AAA) for the S corporation, which is a measure of the company’s accumulated income, less expenses, that have not been distributed. In other words, this is similar to the concept of retained earnings but is calculated specifically for tax purposes. We will forego discussing further nuances of the tax minutia for the scope of our discussion.

By general rule, the AAA cannot be decreased below zero for distributions made by the S corporation. If a corporation makes a distribution of a greater value than the remaining AAA balance on line 6 of the Schedule M-2, the distributions on line 7 of the Schedule M-2 will be limited to the value on line 6 and will differ from the amount reported on line 16d of the Schedule K. In our analyst’s example, the S corporation actually distributed $80,000 to its shareholders during the year. The tax code simply limits the amount that can be reported on line 7 of the Schedule M-2 due to the nuances involved in calculating AAA.

How This Impacts Your Tax Return Analysis

We recommend that when spreading an S corporation return with this scenario, record the true distributions as reported on line 16d of Schedule K. If your analysis showed an out-of-balance retained earnings reconciliation, this adjustment should bring retained earnings back in balance and provide the most accurate cash flow analysis.

If you’re interested in more detailed explanations like this, take a look at Bukers Academy Online. Our new online training platform breaks down complex topics like this into interactive learning modules designed to teach the advanced concepts necessary to analyze complex tax returns.

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Why AGI Is Not a Reliable indicator of Borrower Cash Flow

Steven Buker — Tue, 19 Mar 2024 15:51:08 +0000

Why AGI is Not a Reliable Indicator of Borrower Cash Flow

We have heard this question and/or argument since we started teaching Taxanalysis almost 40 years ago. Some people want to keep their tax return analysis “simple” because it makes them more “efficient,” even though AGI and AGI-based approaches lead to amazingly wrong cash flows. That has never been more true than in today’s tax environment.

The worst thing about AGI-based approaches to personal cash flow is it leads to overstated cash flows. In other words, the borrower appears to have more cash flow than is really true. The loan officer lends against this incorrect overstated cash flow, the loan defaults and the loan officer asks, “What happened?” In a nutshell, the lender assumes that AGI and Taxable Income reported on page 1 of Form 1040 are actual cash flow. They are not. Taxable income and actual cash flow are two entirely different things.

Here are just a few scenarios to think about:

Salary can be overstated in the hundreds of thousands by the exercise of stock options. The “paper” gain upon exercise of the options gets added to salary and suddenly we have cash salary of $60,000 go to $360,000 and $300,000 of it is “paper.”
Take a developer or high-income individual with large interest and dividend income passing through to Schedule B from a K-1. Suddenly interest income zooms from $6,000 cash interest and dividends to $42,000 and $36,000 is “paper.”
Schedule D has a $525,000 gain pass through from a K-1 on a partnership real estate sale where the actual cash distributions related to it were only $125,000. In this case, almost all the sales proceeds of the property were used to pay off debt encumbering the asset at time of sale so there was very little available to distribute from the partnership.
Partnership income passed through and reported on the Schedule E totaled $325,000 when distributions were only $165,000. Or S corp income…ditto.

It just goes on and on. To properly “correct” AGI back to real cash flow, we find there are no less than 87 adjustments that need to be made. Without every one of those adjustments, you are left with overstated cash flows. If you’re using an AGI-based system you have this problem and may not realize it. The Federal and State regulators are acutely aware of this issue. Accurate cash flow analysis requires careful thought and attention to detail. There are no shortcut “exceptions.” Don’t be caught by this!

Our Bukers Online Academy teaches the theory laid out above, and so much more. If you’re a lender or analyst who wants to take your analysis to the next level, enroll in Bukers Online Academy today. We break down all these topics into interactive learning modules to teach the advanced concepts necessary to analyze the most complex tax returns.

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Schedule D Real Estate Sales: Overlooked Adjustments That Impact Cash Flow

Steven Buker — Wed, 21 Feb 2024 20:34:00 +0000

Schedule D Real Estate Sales: Overlooked Adjustments That Impact Cash Flow

The Schedule D reports capital gains and losses from the sales of investment assets. When a borrower sells real estate, the transaction will be reported on the Schedule D. There are two very critical adjustments we need to make for our cash flow analysis that are consistently overlooked. Please note, these adjustments should also be considered with asset sales reported on Form 4797. Let’s break them down.

Schedule D Scenario

A Schedule D shows a sale of real estate (raw land) in Part II with a long-term capital gain of $675,000. It was originally bought years ago for $445,000 and refinanced twice in its lifetime. It recently sold for $1,120,000.

Cash Flow Analysis

The lender initially looking at this tax return may think the cash from the sale is the gain of $675,000. That is wrong. To calculate the cash flow from asset sales on either Schedule D or Form 4797 requires a three step approach.

Step 1 – Start with Sales Price

The first step is to add the total “Sales Price” which in this case is the $1,120,000.

Step 2 – The First Critical Adjustment

The second step, which is the first critical adjustment, is to subtract any debt paid off at closing when this property was sold. A quick check of the closing statement reveals that debt paid off at closing was $780,000. This amount needs to be subtracted from the Sales Price in Step 1 which reduces the cash from the sale.

Step 3 – The Second Critical Adjustment

The third step, which is the second critical adjustment, is to subtract any portion of the net cash from the sale that was reinvested in like real estate. A quick call to the borrower reveals that $250,000 was used to purchase another piece of property. So, you need to subtract $250,000 from the remaining cash in Step 2.

Net Cash Flow from the Sale

This leaves $90,000 available to the borrower, after all the smoke clears, for “other” debt servicing and is all that you should attribute to them as cash flow.

Final Assessment

Again, with any asset sale on Schedule D or Form 4797 (but particularly so with real estate since it so frequently has large debt paid down at closing) you should make a three-point series of adjustments:

Note, the adjustments in Steps 2 and 3 are not items that will be included with your borrower’s Form 1040 tax return. With real estate transactions, you need to request closing statements or specifically ask your borrower for the debt paid down at closing and any amounts reinvested. If someone tells you to just pick up the net gain, that is WRONG and they are not thinking through this fully.

Our brand new Bukers Online Academy training course discusses these two adjustments in detail, along with so much more. Whether your lenders and analysts are new to spreading tax returns or have years of experience, they will improve their skills through our training.

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Form 8990 and Business Interest Expense: Cash Flow Considerations

Steven Buker — Tue, 09 Jan 2024 21:56:43 +0000

Form 8990 and Business Interest Expense:

Cash Flow Considerations

Have you ever come across the Form 8990 in an individual or business tax return and wondered if this impacts your cash flow analysis? This form can provide key information regarding the total interest expense paid by an individual or business; here’s what you should know.

Section 163(j): Limitation on Business Interest Expense

One of the more notable tax changes from the Tax Cuts and Jobs Act was the amendment of Section 163(j) to limit the deductibility of interest expense for individuals, pass-through entities, and corporations. The interest expense deduction limit is based on a number of factors, but lenders should just be aware that a discrepancy may exist between interest expense deducted and actual interest expense paid by the entity or individual.

There is an important exclusion that allows “small business” taxpayers and entities to avoid the limitation of the interest expense deduction. Many borrowers will not have to worry about their interest expense deduction being limited by the IRS, as long as their average gross receipts are less than $27 million over the prior three-year span. There are some exceptions to that rule which may cause an entity to file a Form 8990 for informational purposes without having its interest expense deduction limited.

Form 8990: Main Takeaway

The main takeaway from all of this information is to be aware that there may need to be an adjustment in arriving at actual interest expense paid for taxpayers who are limited by Section 163(j). The good news for lenders is that Form 8990 shows the breakdown of actual interest expense paid versus what was allowed as a deduction on the tax return. Generally, Part I, Section I, Line 1 reports the total current year interest expense prior to the application of the limitation. However, there are numerous caveats and exceptions that may be applicable, depending on your borrower’s facts and circumstances.

This is a complex tax issue that even confuses seasoned tax professionals. The bottom line for your cash flow analysis is to ensure that you’re capturing the total interest expense paid by your borrower.

To better understand how Section 163(j) and the Form 8990 impacts your tax return spreading process, please call into our team of experts through the Bukers Hotline at 503-520-1303. We look forward to hearing from you.

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K-1 Contributions: Cash vs. Noncash

Steven Buker — Wed, 15 Nov 2023 23:16:40 +0000

K-1 Contributions: Cash vs. Noncash

Are They Capital Contributions or Charitable Contributions?

Have you ever looked at the Schedule K-1 from an S corporation and found values reported on Line 12 Other Deductions with corresponding letter codes, but no description of the actual deduction? An analyst recently called into the Bukers Hotline with a K-1 showing:

This analyst is sharp and looked up the K-1 codes for the Schedule K-1 (Form 1120-S). Per the List of Codes found in the IRS publication Shareholder’s Instructions for Schedule K-1, Code A on Line 12 reports “Cash contributions” and Code C on Line 12 reports “Noncash contributions.” She asked if these line items refer to capital contributions made to the S corporation from the shareholder.

Good question! What's the answer?

These two line items on the K-1 do not represent capital contributions. Instead, these values refer to charitable contributions (donations) made by the S corporation to charitable organizations. Line 12, Code A reports contributions of cash to charities while Line 12, Code C reports the value of property, such as equipment and office furniture, donated to charities.

The values reported on Line 12, Code A and Line 12, Code C of the K-1 represent the shareholder’s respective share of the charitable donations made by the S corporation. These are not actual capital contributions of any sort; they should be ignored and not included as a cash flow item to the borrower.

Note: The same applies to K-1s from partnerships; the only difference is that Other Deductions are reported on Line 13 of the Schedule K-1 (Form 1065). Specifically, Line 13, Code A reports cash contributions to charities and Line 13, Code C reports noncash contributions to charities. You can find more detail on the partnership K-1 codes in the IRS publication Partner’s Instructions for Schedule K-1. We apply the same logic to a partnership K-1. These are not actual capital contributions and should not be included as a cash flow item to the borrower.

Do you have questions like this when analyzing tax returns or financial statements? Reach out to our team of experts through the Bukers Hotline at 503-520-1303. You may also submit a question through our website and we will quickly get back to you.

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