A revealing conversation with a customer's tax return. Interesting, this....

In my seminars, I teach bankers how to extract useful information from the customer's personal and business tax returns. It occurred to me that I've never attempted to describe the process to myself, let alone others. That's about to change.

Truth be told, the tax return talks to me - like the narrator of a good story. Sometimes the story takes the form of a mystery, a drama occasionally. But always alive - moving toward something. Not knowing where it will lead keeps me engaged; the twists and turns of the journey of equal import to the destination. And, I've learned that the tax return is soft spoken, never shouts. I've had to train myself to listen with an educated ear.

Sound ' a little odd'? Maybe, but it works for me. And it may work for you.

Scene - mid morning, banker's office

It's early December and cold where I live. The sky foretells snow again. A fresh cup of coffee at hand, I'm ready to look at my customer's tax return. Once, I dreaded doing so; unfathomable document required as part of the bank's credit process. Better snap to it. I open the return.

"Well, what took you so long?" a whispered voice says. It's the voice I've always found soothing, almost, but not quite, hypnotic. You know the kind. Sister Mary Joseph, fifth grade, leaning over my shoulder explaining a great mystery of math.

"Pardon," I said aloud, not certain the voice's source.

"I've been sitting in the customer's file forever - it's good to get out,"the voice continued

"Sorry that," I offered.

"Apology accepted - let's get to it," replies the voice.

" I admit I don't know if you can help," I said.

"What are you looking for?" the voice again.

"Okay - tell me everything you know," I said. I tend to make this all inclusive request when I'm unsure how to be more specific.

"May take awhile," came the reply, "Ask me questions as you move through my pages and schedules."

Form 1040, Page 1

Filing status selected. This can help you start thinking about the cash flow demands on your customer. And, it can suggest other issues at play. For instance, 'married filing separately' is unusual; there must be a reason why the couple chose this tax status. The reason may affect your cash flow calculation of the borrower or guarantor. 'Head of household' is becoming more common; hints to increased cash flow demands on the household. Same holds for 'qualifying widow(er) with dependent child'.

"No surprise here - dependents 'eat' cash flow," I heard.

The rest of Page 1, Form 1040 is an exercise in computing the 'Adjusted Gross Income' (AGI). For many bankers, AGI is the starting point in calculating the customer's personal cash flow.

Specifically, lines 7 - 22 gather the gross taxable income (loss) items from other schedules within the tax return. Lines 23 - 36 list the adjustments (subtractions) and some of these are telling. Some are associated with the customer's funding of deferred compensation plans (IRA, Self-employed SEP, SIMPLE).

"I can tell you taxpayers will beg, borrow, or steal to make their IRA contribution," the voice said. "It's a high priority for them".

"If there's anything good about paying alimony, it's that it's deductible in computing AGI," I heard, "Small comfort I suspect. And, it's got to be paid in cash - so the cash is gone."

"Here's a sleeper," the voice continued, "It's called the 'domestic production activities deduction'. Ever hear of it?"

"Not really," I said.

It strongly suggests your customer owns a business that qualifies for this credit. And that business is likely a pass through entity (S corporation, partnership, or limited liability company). It's not direct cash outflow as far your customer is concerned. A 'global cash flow' model now becomes germane.

Page 2, Form 1040

Did your customer take the standard deduction, or itemize their deductions?  A customer taking the standard deduction likely does not have huge cash outflows for out-of-pocket medical expenses, interest of non personal debt (mortgage(s) in the main), State and local taxes, charitable giving, and miscellaneous deductible items. The converse is likely true if deductions are itemized; the cash outflows may be substantial.

Schedule A   Itemized Deductions

Schedule A  lists the itemized deductions. Most itemized deductions require cash outflow with very limited exceptions (non cash charitable giving comes to mind). Interest paid on home mortgage(s) is likely to be one of the largest amounts. Interest on personal debt is not deductible; not reported on Schedule A, but that personal debt might well exist. State and local taxes paid can be large as well.

"Which do you see more often - standard or itemized?" I asked.

"Depends on the return's complexity," the voice said, "If it's complex the taxpayer usually itemizes. If it's a simple return, they'll use the standard."

The tax is reported on Page 2 as well. Cash outflow to be sure.

Alternative Minimum Tax

"I see the alternative minimum tax was paid by my customer," I said, 'But I really don't understand it."

"You're not alone - few understand it but many pay it," came the reply, "And, it's usually called the AMT."

What does it's activation tell you? On complex tax returns displaying large gross income generation, it likely suggests your customer uses tax planning to drive down the regular tax reported on line 44. Nothing right, or wrong, with this approach, but rather a caution to you when using the taxable income (loss) numbers from the return in chasing cash flow. Those numbers are net of the various tax planning moves. You'll need to unwind the tax planning to get a true read of the cash flows.

"So, if I see the AMT being paid, it means my customer is aggressive in their tax planning?" I added.

"That conclusion was always true many years ago, but no longer," came the reply. "You no longer have to be an aggressive tax planner to trigger the AMT. It's simply a second, stand alone tax computation today. You compute your tax two ways - the normal method as the form instructs resulting in the regular tax. Next, you calculate the AMT. You pay the higher of these two taxes," I heard.

"How do you know which one will be the greater?" I responded.

"Well, good question. If you're an aggressive tax planner, you can be fairly certain the AMT will get you," came the reply. "Absent that, you have to compute them both to see which you'll pay."

"Does this thinking follow?" I asked. "From a cash flow perspective, it's moot which tax is paid; the cash is gone."

"Exactly, but there is value in knowing if the AMT was triggered because the customer truly is aggressive in their tax planning," the voice continued. "That aggressive tax planning is distorting the numbers you see reported on the return. You'll have to make adjustments to them in chasing cash flow."

"One more point - if your customer is aggressive in their tax planning, it's likely they're aggressive in other areas as well," the voice offered, "Maybe in your relationship."

The rest of Page 2, Form 1040 is littered with credits of one sort or another. An explosion of credits over the past ten years or so. Not a problem on the face - tax has been reduced by the credits, cash flow enhanced. But, securing most credits (non refundable type) requires cash outflows that dwarf the amount of the credit.

Return Preparer

Who prepared the tax return - customer or paid professional (CPA, attorney, etc.)? If paid professional, a much better chance that tax planning supports the numbers.

I couldn't resist and asked, "Who do you prefer prepare you?"

"I'm partial to the CPA," came the reply, "More appreciation of the intricate design and flow of the numbers and concepts imbedded in my schedules. I like working with an informed person. It's not necessary they love me, just understand how I function."

Schedule B   Interest, Dividend Income

Schedule B lists interest and dividend income. This schedule can be informative. Where does the interest income originate? Third party payor (bank, S&L, credit union, other)? Maybe it comes from loans made to persons (or entities) related to the customer. If related entity, maybe an opportunity to include that entity in the global cash flow model. And, if you're not banking that related entity, why not? Ask for the business.

Is the interest you see on Schedule B the cash they got? Most likely it is cash, but there are situations where the interest income is 'imputed' to the customer and pick up as taxable on Schedule B even though your customer did not get the cash. Most likely to happen when there are loans to related business entities.

"I often see interest, and to a lesser extent, dividend income reported in the name of a business I know my customer owns," I said and continued, "And it's sometimes confusing."

"It's really simple when you 'step it out'," the voice said. I suspect you're really concerned with the cash flow aspects."

"That's true," I admitted.

"Swell, so start with this assumption 'what you see is what they got in cash'," the voice offered, and continued, "But there are some major exceptions, pass through interest and dividend income by far the most common."

"Explain pass- through to me; I think I know how it works, but maybe not," I said.

The voice went on, "Some business entity formats get special tax treatment when compared to a regular (sometimes referred to as a 'C' corporation). A regular corporation pays an income tax at the entity level if it has a taxable income. The interest and dividend income it earns is included in its taxable income, the tax paid by the corporation. With me so far?"

"Got it," I replied.

"Partnerships, S corporations, multiple member limited liability companies, and certain kinds of trusts do not pay an income tax at the entity level. Rather, they 'pass-through' the various kinds of income they earn (including interest and dividends) to their owners. The owners included this 'passed-through' income on the various schedule and forms within me. Interest and dividends are reported on my Schedule B, usually in the name of the entity. All right and proper," said the voice.

The voice could sense my hesitation, and asked, "What's troubling you?"

"Did the owners actually get cash - was cash passed-through to them?" I asked.

"Maybe, but that's highly unlikely. Probably not," the voice offered, "But the receipt of cash has nothing to do with reporting of the income on Schedule B. The passed-through amount ends up of Schedule B simply by operation of tax law. Cash received (or not) is moot."

"So, how do I treat the pass-through interest, dividend income?" I asked.

"Ignore it - don't count it as cash inflow," came the quick reply.

"What if my customer makes an interest bearing loan to the business," I asked and continued, "Can I assume cash was received for that amount?"

"Yes, it's very likely your customer got the cash, particularly if they control the business," came the reply.

"But what if the business is a pass-through entity, how do I know if the amount on your Schedule B is 'pass-through' interest, or owner loan interest - each reported in the name of the business?" I pushed on.

"That's easy - go to the Schedule K-1 for that business and look at the amount of interest 'passed-through'," the voice said and then continued, "Then compare that amount with the amount on my Schedule B. The amount on the Schedule K-1 is the 'pass-through' (assumed non cash), the rest in interest income on the owner loan (assumed cash inflow). Works every time," came the reply.

"One more question about your Schedule B," I ventured, "I've seen 'installment sale interest income' reported there. What is it and is it cash inflow?"

"Yes, it's cash inflow," came the reply, "Now, find my Form 6252."

Form 6252   Installment Sale Income

I flipped to Form 6252; found it toward the back of the return.

"I'm there," I said.

"When you sell a capital asset and the terms of the sale have you receiving a payment after the year of sale, you're automatically covered under the installment sale method," the voice said, then added, "And that's a good thing for most taxpayers."

"Why?"' I asked.

"The installment sale method lets you pay the tax on the gain as you receive the payments," was the reply. "Absent the installment sale method, the entire tax would be due in the year of the sale! Tax due - no cash to pay it. Not pretty."

The voice continued, "The interest received on the contract is picked up on my Schedule B, and it's cash received. Include it in your customer's personal cash flow."

"I see on your Form 6252 the principal received in the year - do I include that as cash inflow too?", I said, and asked.

"Maybe, depends on if you're including capital transactions in your customer's cash flow," came the reply. "Some bankers exclude capital gains and losses from cash flow because they tend to be non recurring, one time only - can't count on them each year."

"Well, what if I can be reasonably sure the cash payment of principal will be received?", I asked.

"What - you have a crystal ball or something?', the voice asked partly in jest.

"No, but maybe the contract is far enough into its term that it's unlikely the buyer will walk," I added.

"Then you might consider including the cash principal received in the cash flow," I heard.

Schedule C   Business Income (Loss)

I flip to the Schedule C in my customer's return. The voice notices, and says, "Ah, you've found one of the most commonly audited schedules in me. Put a Schedule C in the return and you're much more likely to be audited by the IRS."

"Why?", I asked.

"IRS usually comes away with more tax!" came the reply, "Games are played on my Schedule C."

"What type of business files a Schedule C?", I asked. I've been confused on this in the past.

"Schedule C was designed for the sole proprietorship (hence the notation on the form) a long time ago; today other business formats may use it," I heard.

"Such as...", I prompted.

"A single owner limited liability company is the most common today - I see more of these using my Schedule C than true sole proprietorships," was the reply.

"Can any limited liability company use Schedule C?", I asked.

"Just one that's owned by one, natural person - a 'carbon based unit'," a chuckled response.

"Does a single owner limited liability company always file Schedule C?" I asked, but I thought I knew the probable answer.

"Not always - depends on the choice it made in its first year," the voice offered. "Want to learn more about the available choices?" the voice asked. "Here's a link to an article written by a very knowledgeable person on point."

• I'm confused - just how is a limited liability company taxed?

"Can you give me a guick way to compute the business cash flow using the Schedule C?" I asked.

"Sure", the voice replied, and added, "First, look at the accounting method used. If it's the cash method, most of the numbers on the Schedule C are already cash based - revenue is cash in, expenses are cash out. One exception though, and that's depreciation expense. It's a non cash expense. Next, take the net income (loss) on the Schedule C and add to it the depreciation amount. Bingo - the cash flow."

"That makes sense," I said and then asked, "What if it's the accrual method?"

"Tougher, that - you'll have to measure the change in some key accrual accounts to glean the cash flow", I heard, followed by, "And my Schedule C will not be of any help with that. No balance sheet in my form. You'd have to get the info from another source."

"Swell," I offered sarcastically.

I paused and continued to look at the Schedule C. I could sense the voice was waiting for me to ask another question. Found one.

"What other items on your Schedule C might give me a 'false read' of the cash flow?" I queried.

"Expense paid to a 'realted party' comes to mind," came the reply, and continued, "That's because the cash expense on the Schedule C is likely matched with cash revenue to the related entity. If using a global cash flow model, and I've heard that's what many bankers (like yourself) do, it's a cash flow wash."

"Anything else?" I asked.

"Oh, almost forgot", the voice said and added, "sometimes the preparer (most likely a professional) will hide, or bury the interest expense. Interest paid will not be reported on the lines I provide on the form; rather, it will be reported as 'other business expense'."

"Why do that?", I asked.

"Just as some tax forms or schedules carry a 'higher than the norm' audit potential, so do certain lines on those forms," came the reply, and added, "Interest paid and expensed on my Schedule C is one such line."

"Because...", I prompted for an explanation.

"Interest paid on personal debt is not deductible - that's been true for a long time," came the reply. "When the IRS auditor sees interest expense deducted on the provided line(s) of my Schedule C, the auditor is required to question the true business nature of the underlying debt. They often find personal debt masquerading as business debt. So, some preparers report the interest paid as other business  expense to avoid the interest paid lines. Not saying it's the proper way - just saying I've seen it done."

"Interest paid is important to me calculating cash flow," I said and added, "Because I'm after cash flow before debt service. Seems to me I'd be wise to check the composition of the other business expense category."

"My thoughts exactly," came the affirmation.

"What if the business is a single owner limited liability company owning rental real estate - does it use your Schedule C?" I asked.

"Rental real estate is always reported on my Schedule E, Page 1 when it's owned individually, or by a single owner limited liability company - not on Schedule C," said the voice.

Schedule D  Capital Gains and Losses

I moved to Schedule D, and asked, "What can this form tell me?"

"Well, it can indicate the size of your customer's investment portfolio, and the frequency of trading activity," the voice said, and then continued, "But it's unlikely you'll use it for cash flow purposes."

"Why would that be true ... the cash flow part?" I asked.

"Most bankers exclude the cash flows associated with capital transactions from their customer's personal cash flow. For most, capital gains and losses, and the associated cash flows, are not reliable, non recurring, one time only transactions. They distort the recurring cash flow, so most bankers ignore them," was the reply.

"So, no value for me then," I said.

"Not entirely true - you could ask for the customer's brokerage business," the voice offered.

Form 4797   Sale of Business Property

"Here's a form I know nothing about - Form 4797," I said and added, "What can you tell me about it?"

"It's linked to my Schedule D we just discussed," the reply, and then, "And it's used when a business asset is sold. Its main function is to make sure any depreciation recapture is taxed as ordinary income rather than as a capital gain."

"Cash flow implications?" I asked.

"Nope, same logic as capital gains and losses - non recurring," the voice replied.

Schedule E   Supplemental Income and Loss

Many of my customers have rental real estate, so I've seen this form before and feel I have a good grasp of page 1. That's not the case with page 2.

"Tell me about your Schedule E - I'm all ears," I said, folding my arms and leaning back in my chair.

"My Schedule E has two, distinct parts. The first part reports rental real estate and royalty activities, the second part lists the pass-through entities by name and the pass-through income or loss," the voice said.

"Let's talk about the rental real estate part," I said. I have many customers owning rental real estate.

"Will do," came the reply, and continued, "I suspect you're really interested in the cash flow issues of rental real estate, so I'll focus on that. Go to my Schedule E, Page 1."

I flipped the pages and found Schedule E, Page 1. "I'm there," I said.

"Rental real estate, and for that matter, any royalty activity, is reported on my Schedule E, Page 1 only if the activity is owned by the taxpayer outright (individually), or in single owner limited liability company format not choosing corporate taxation," the voice began, and added, "This can be tricky."

"Here's a test for you - answer as best you can," the voice instructed.

"First question - if the real estate is owned by more than one person, is Schedule E, Page 1 used?" the voice put the question to me, and I could sense with pleasure.

"Can't use Schedule E, Page 1 because the real estate is owned by more than one person," I answered confidently.

"Exactly - the rental real estate would be owned in a partnership, C or S corporation, multiple member limited liability company, trust, etc.," the voice said.

Continuing, I heard, "Most of the rental real estate properties reported on my Schedule E, Page 1 are owned by single owner LLCs, and that's been true for some years now. You can't tell that by looking at Schedule E, Page 1 - my form just asks for the property's address, not how it's owned."

"Why do I care how the property is owned?" I asked.

"Ownership can impact your customer's personal cash flow," came the reply, and continued, "And that's why you should care. Works like this. Think about it - the LLC is a legal entity, a person in law. Its cash flow belongs to it and not to the LLC's owner. That being said and accepted, it is technically incorrect to include its cash flow in your customer's personal cash flow unless you're building a global cash flow. But, most bankers, like yourself, are after a global cash flow, so they ignore the legalities of ownership and include the LLC's cash flow as part of the customer's personal cash flow."

"What should I do?" I asked.

"How conservative do you want to be with the cash flow?" the voice asked.

"Very - that seems to be the flavor of choice now," I replied.

"If using a global cash flow model, and your bank is the only bank of the single owner LLC, include the cash flow of the LLC in the customer's personal cash flow. If there's another bank in play, exclude the positive cash flow from your customer's cash flow. Then, regardless of ownership, subtract any cash outflow from the customer's cash flow," the voice said.

"Why exclude the positive cash flow if there's another bank in play?" I asked.

The reply was swift and sure, "Maybe the LLC borrowed from that other bank and there are restrictions on cash distributions within the loan agreement. You stand behind that bank - why pretend you have access the LLC's positive cash flow if your interest is subordinated? Isn't the whole idea of using a global cash flow approach to gain some comfort rather than creating more anxiety?"

"Makes sense," I replied.

"You always subtract the single owner LLC's negative cash flow from the customer's personal cash flow," the voice continued, "Because it's just a matter of time before the owner will have to feed the LLC's appetite for cash with a cash infusion as capital, or additional borrowing. Conservative enough for you?"

• Want more information about Schedule E, Page 1? Follow this link.

"Works for me," I said and added, "What can you tell me about Schedule E, Page 2?"

"Well, it's misunderstood by many bankers and that's an understatement," the voice said. "Mostly, I see bankers over working the numbers they find on my Schedule E, Page 2. Many simply think they must do something with the numbers if for no other reason than they are often substantial. I watch them work and re-work the numbers, becoming increasingly frustrated. All for nought." 

"I've been there," I admitted.

"Really, my Schedule E, Page 2 has very little useful information of a direct nature," the voice said and continued, "Most is purely suggestive. The names of the business interests your customer owns, in whole or in part, are listed by name, federal identification number, type, if they are pass-through entities. That's the direct information. Seems to me you'd want to know that if you're pursuing a global cash flow - tells you which entities you need get information about, which Schedule K-1s to ask your customer for. That's the extent of the direct information."

I asked ,"What about the numbers?"

The voice continued, "The rest of the information is purely indirect, suggestive in nature. And that includes the numbers. I say this because you really don't use the numbers in your customer's cash flow, but they can suggest a course of action. Here's an example of what I mean. Suppose the business shows a loss on my Schedule E, Page 2. My first thought has to do with the nature of that loss - is it manufactured for tax purposes, possibly driven by accelerated depreciation on major assets, or might it be an economic loss possibly involving cash disbursements in excess of cash revenues? Can't answer these questions using my Schedule E, Page - you'd have to look at the tax return of the business. So, my Schedule E, Page 2 is suggestive."

"I see your point," I said.

"Now, if all you're interested in is the effect of the business on your customer's current cash flow sans global cash flow, my Schedule K-1 is the key," the voice offered, and then continued. "It shows the distributions your customer received during the year. And, those distributions are likely to be cash based. Further, the Schedule K-1 shows the capital contributed by your customer during the year, and that, too, is likely to be cash based."

• Want more information about Schedule E, Page 2? Follow this lnk.

My attention span was waning and I said, "I need to think about what you've told me, and I have questions about business tax returns. Can you help me with those?"

"Certainly, but next time we talk," the voice answered.

"Thanks for the chat," I said, just a little sad the conversation was ending.

"My pleasure," came the fading reply.