Arthur’s question:
Should 1065 K-1 guaranteed payments be subtracted from company cashflow when finding debt service? Most of my career has centered on CRE loan underwriting and origination. The CRE view is that debt is senior to obligations to pay owners, and that guaranteed payments and other cash distributions are discretionary. With that thinking, the payments to the owners should not be considered.
Linda says:
Global cash flow, K-1 and guaranteed payments combined. Throw in the difference between CRE an C&I lending, and this is a great question. And yes, the difference in approach is certainly related to the comparison of CRE to C&I.
Guaranteed payments and distributions as owner compensation
Consider a company in which the owner is also the President and works full time in the business. If an S Corporation, they choose to pay some of their compensation as wages but often they choose to pay a significant amount in distributions instead. They do this because they pay no payroll taxes on distributions but do pay payroll taxes on wages. It is common practice, therefore, for the distributions in an S Corporations to owner/employees to be a normal form of compensation.
If an LLC or partnership filing a 1065, the only way owner compensation is made, from a tax return perspective, is the combination of distributions and guaranteed payments. If you do not consider those amounts as a use of cash-flow before debt payment, then you are saying that the owner/employees just do not need to get paid or are completely willing to forego their compensation.
In a pinch, that may be true. But underwriting in a way that requires owner/employees to forego compensation in order to make the business debt payments implies that the company is not strong enough to both pay the owner/employees for the work they do in the company and cover business debt.
The big difference here is that in C&I lending, shareholder or owner distributions and guaranteed payments often are the 'normal' compensation related to their employment rather than a distribution from an investment. And yes, owner distributions can be more of a return on investment than compensation for services.
A clue
If it is guaranteed payments on a 1065 K-1, see if the Self-Employed Earnings down on K-1 Line 14 includes the Guaranteed Payments. If so, they are compensation for services rather than guaranteed payments related to capital.
More help
The 3-module set on 1065 Tax Return Analysis, along with the 3 modules on S Corporations, are a good resource. You can take a free module at www.LendersOnlineTraining.com to try out this online option for tax return analysis cashflow training.
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