Whose Income is K-1 Income Anyway, Mine or My Business’?
A client of ours who is contemplating applying for a mortgage loan to buy a house, recently asked me if their business profit can be considered part of their personal income. My short answer to this question was, “Well, theoretically, yes.” But then it occurred to me how confusing these tax laws are to small business owners, particularly those who are taxed on this income personally, even though they may never have actually received the cash themselves in their personal bank account.
This client like many small businesses, files their business tax return as an 1120-S, “S-Corporation,” wherein their business profit is taxed on their personal tax return. For tax purposes there are several advantages to filing taxes this way (which is a topic for another article). But it certainly does create much confusion for both small business owners and some kinds of lenders.
So, I provided the following clarification to our client:
“To clarify, your profit is treated as income to you on your personal tax return, regardless of whether you actually “distribute” cash to yourselves. Then Cash distributions are reflected on your Cash Flow Statement. What we do is show the payments you make to yourselves during the year as “loans” from the company to you, and then at the end of the year, reclassify them as “distributions” based on your final profit.
“Some businesses cannot afford to distribute their profit to the owners because it’s needed to finance sales growth (i.e., increased accounts receivable and inventory), pay back business loans, etc., and (knowledgeable) lenders look at these kinds of things.
“In your case, you are not affected by these issues because you receive customer deposits up front which pay your material costs, so you are able to pay distributions to yourself. But this might have to be explained and proven to the lender depending on the lender you’re talking to. In a bank, you would want to be dealing with a “business banker.” If you’re dealing with other kinds of lenders, they may be strictly “consumer” lenders who may not understand business financial statements.”
And once again, there is a huge difference between “business profit” which you look at to evaluate the performance of your business, and what is considered “taxable income” to the IRS. I’ve written numerous articles about this in our blog. But the really sad thing is, the banking industry today relies heavily on tax returns for their own underwriting convenience. Consequently, many of today’s small business lenders have also lost sight of these important differences, which in my view, has done a disservice to their small business customers.