How to Treat Interest Expense from Schedule K for Cash Flow Analysis
Introduction
We recently received a call on the Bukers Hotline that discussed a fairly uncommon occurrence on a business tax return. The analyst had a partnership tax return on Form 1065, and was examining the statement detail for Schedule K, Line 13e – Other Deductions. On that statement detail, the analyst noticed an entry for “interest expense on loan proceeds distributed” for a material amount. The analyst asked our CPA on the Bukers Hotline, “what does this amount represent, and what are my adjustments needed for cash flow?” On this week’s newsletter, we will explore this topic and explain how we answered the analyst for their specific situation.
Answering the Analyst
First of all, let’s tackle the immediate issue at hand – what does the “interest expense on loan proceeds distributed” really mean with respect to the analyst’s borrowing business? From what we could tell, this interest expense is related to a loan that the partnership took out and subsequently distributed the proceeds of this loan to its partners. Clearly, the line item description is our primary clue in guiding us to this conclusion. We are also given context clues by the presentation on the tax return.
Typically, we would expect to see interest expense listed on Page 1 of the business return. There, it is combined with other non-separately stated income and expense items to arrive at the subtotal of ordinary business income/(loss). This figure is then passed through to the partners on their respective Schedule K-1, in Box 1 of Part III. However, in our case, the interest expense is not listed on Page 1 of the return; and instead, is presented as an Other Deduction on Schedule K, where all the separately stated items of income and expense are listed. Because it is listed on Schedule K, the interest expense will flow through to the partners’ individual tax returns as a separately stated item.
Therefore, it stands to reason that this interest expense is listed here on the business return so that it can be allocated to each partner respective to their share of loan proceeds received from the business. This interest expense may need to be included for purposes of calculating the borrower’s interest expense limitation on Form 8990, which may be the reason it is presented separately on the business return.
How does this affect our analysis?
Given that we now have an understanding of what this “interest expense on loan proceeds distributed” even means in the first place, how do we treat it for our tax return analysis?
On the business analysis, this item should be treated as interest expense on the Income Statement generated by the business spread. It is important that we classify this properly because interest expense is an addback on the Traditional Cash Flow model and in metrics like EBITDA. If we failed to examine the statement detail related to Schedule K, Line 13e, we run the risk of missing items of addback like interest expense and instead treating those as cash outflows. This error would misstate business cash flow, which could have impacts on our lending decision. Especially if we rely on figures like EBITDA or use the Traditional Cash Flow model, it is always crucial that we look through all statement detail to arrive at the most accurate cash flow figures possible.
On the personal side of this analysis, there is no additional consideration related to cash flow. This interest expense item on Schedule K of the partnership return will flow through to the partners on their respective Schedule K-1. Within our personal cash flow analysis, we are far more focused on items like distributions and/or contributions, which have cash flow impacts to the personal borrower. The interest expense that flows through to the partner’s Schedule K-1 would be ignored in arriving at cash flow, because it would be a “paper” expense only reported for tax purposes, with no cash flow impacts on the individual.
Key Takeaways
Statement detail matters. A quick review of Schedule K supporting schedules can uncover items that belong in your cash flow adjustments and help ensure your business analysis reflects the borrower’s true ability to service debt.
Would you ever want support on questions like this?
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