When your income is distributions, not salary

Owners who pay themselves mostly in distributions present a cash flow figure that looks strong and gets marked down in underwriting. The reason is straightforward: the business's cash flow and the owner's income are the same pool of money, and the analyst has to decide how much of it the owner cannot stop taking.

Global cash flow, and the subtraction owners forget

The naive presentation: 310,000 of EBITDA against a proposed 120,000 of annual debt service gives coverage of 2.58. Strong.

The analyst's version subtracts what the owner must take. Two components:

• Tax distributions. The owner pays personal tax on the company's full 260,000 of net income whether or not it is distributed. At an illustrative 32 percent blended federal and state rate, that is 83,200 that has to leave the business or be funded from the owner's other resources.
• Living costs. Say 95,000 a year, against which the after-tax portion of the 60,000 salary contributes roughly 43,200.

Required owner draw: 83,200 + 95,000 − 43,200 = 135,000.

Cash actually available for debt service: 310,000 − 135,000 = 175,000. Coverage against 120,000 of debt service is 1.46.

Still a good file — but 1.46, not 2.58. If you present 2.58 and the analyst produces 1.46, you have spent your credibility on a number you were never going to keep. Present 1.46, with the working shown, and you are the borrower who understands their own business.

The pass-through tax problem, stated plainly

This is the mechanism that non-owners find counter-intuitive and that owners live with. In an S corporation or a partnership, you are taxed on the entity's income, not on what you received. Leave 260,000 of profit in the business to fund growth and you still owe tax on 260,000.

Consequences for borrowing:

• Retained earnings are not free. Every dollar retained has already been taxed personally, and the cash to pay that tax had to come from somewhere.
• A tax distribution is not discretionary. Lenders who understand pass-throughs treat it as a fixed obligation. Lenders who do not sometimes treat all distributions as discretionary and available for debt service. The second reading gets you a bigger loan and a harder repayment.
• Distributions can exceed income, or fall short of it. Either creates a question. Distributions well above net income drain equity and will be asked about. Distributions well below suggest the owner is living on something else, which will also be asked about.

What the analyst asks for, and what each document does

• Business tax returns, two to three years. The K-1 shows your share of income; the balance sheet shows distributions and the capital account movement.
• Personal tax returns, matching years. These tie the K-1 to what you actually declared and show any other income sources.
• A personal financial statement, showing assets, liabilities and, critically, personal debt service. Your mortgage, car loans and personal card minimums are part of the global calculation.
• A statement of personal living expenses. Many lenders have a form; if not, prepare one. If you do not supply a figure, the analyst will estimate one, and their estimate will be conservative.
• The distribution history by month. Regular monthly distributions read as a wage. Large, irregular ones read as a business whose cash is being taken when it appears, which invites a question about whether it will be available for a payment.

Three things you can do that change the number

The covenant to negotiate before you sign

Loan agreements frequently restrict distributions. A blanket prohibition on distributions while the loan is outstanding is unworkable for a pass-through owner, because you will owe tax on income you cannot take out.

The standard fix is a carve-out permitting distributions sufficient to cover the owners' tax liability on the entity's income, often capped at an agreed rate and conditioned on no default subsisting. Ask for it explicitly. It is routine, it is granted more often than not, and it is very difficult to add after closing.

Read the whole distribution clause while you are there. Some permit tax distributions but prohibit all others; some allow distributions only if a coverage test is met after payment; some require lender consent each time. Each of those is livable if you know about it in advance and unlivable if you find out in March.

What to ask for, what to have ready, what to refuse