Understanding Personal Cash Flow
By Brian Schwerdtfeger, Director, Advisory Services
Tax returns are confusing. We all understand what a W-2 is and where our interest and dividends go on a personal tax return, but what about when the taxpayer is also a business owner? What kind of business do they have? How is it reported on the tax return? How do you know what income is just being reported on the tax return vs. what is actual cash flow received? Attorneys often hire us to figure out the answer to that question. Here, we’ll go into a bit of detail about some differences between taxable income and true cash flow and what information we typically rely on to determine true cash flow.
Taxable Income versus Cash Flow
Taxable income, as reported on an individual income tax return, does not necessarily represent cash received by the taxpayer. This is especially true of the taxable income related to a person’s ownership interests in partnerships, limited liability companies, S corporations and other ‘flow-through’ or ‘pass-through’ entities. Pass-through entities are generally not subject to tax on income at the entity level. Cash flow is essentially all cash generated by a party over a specific period of time. Using the individual income tax returns as a foundation, we make certain adjustments to those figures to arrive at gross cash flow.
Below are just a few examples of how taxable income and true cash flow differ.
The wages on page 1 of the tax return are just the taxable portion of those wages in that year. In cases where the employee is part of a retirement plan and contributes a portion of their income to a pre-tax 401(k) plan, that portion of wages will not be reported on their tax return in that year, but it is still a benefit being received by them.
Another situation that may occur has to do with deferred compensation, which includes items such as stock options, restricted stock, stock appreciation rights, etc. These incentives are common forms of compensation for executive and other professionals at publicly traded companies. They are generally treated as assets in a divorce, but the tax treatment of such incentives can make calculating income or cash flow difficult. Income may be earned in one year but not paid out until another year.
Schedule E businesses
These types of businesses can make deciphering your personal tax return very difficult. Income (interest, dividend, capital gains and ordinary income) generated by these entities is passed through to the shareholders of the entity, and subsequently taxed on the federal and state personal tax returns of the shareholder, even if no cash is actually received.
Conversely, distributions made by a pass-through entity to its shareholders generally represent cash amounts paid to those shareholders and are not reflected as taxable income on the interest holder’s tax return. The income or gains generated may not actually be paid out in the year it is incurred.
Additionally, it is not uncommon that we come across situations whereby a business owner has personal expenses paid for by the business. These personal expenses may be picked up as a business expense thereby reducing income as opposed to being reported as taxable income on their tax returns. It is certainly a benefit received by the business owner that is not reflected in their income.
Documents Needed to Perform a Cash Flow AnalysisSo, what types of documents do we need to determine actual cash flow? Let’s take the example of the pass-through business owner running personal expenses through their company. We’ll start with the owner’s individual tax return to determine all of the sources of income. Upon seeing that they are reporting some activity from a Schedule E business, we will look to their business tax returns and individual K-1 to see what types of income are being reported (i.e., operating income, interest, dividends, or capital gains) and, more importantly, the amount of distributions the company paid them for that year.
Then, we can scrutinize the financial statements provided to us by analyzing the general ledgers to see which personal expenses are paid for by the business, whether it be mortgage or car payments coming out of the checking account, through personal credit cards being paid for by the business, or simply personal expenses on the company card. Sometimes with very small businesses, the general ledgers do not even provide complete transaction detail and we must get access to bank and credit card statements for the whole picture.
All of these expenses are a cash flow benefit to the owner regardless of whether or not they are being taxed. If these personal expenses are properly accounted for, they will be removed from the operating expenses and, ideally, classified as a shareholder distribution. In that case, the distribution amount on their K-1 is an accurate representation of their true cash flow and income is properly stated. On the other hand, if these expenses are not eliminated from the business or are sneakily reclassified as a shareholder loan instead, the distribution amount on the K-1 will not be accurate and we must add back the additional cash flow benefit.
The previous example is just one common form of under-reporting cash flow and income but, rest assured, there are many more ways out there. Having a team of professionals that can decipher tax forms, financial documents, and understand the sneaky ways of concealing income is the first step to getting past page 1 of a tax return and calculating true cash flow.