K-1 Cash Distributions: Is It the Right Cash Flow?

We should all understand by now that income is not cash flow. We understand the income statement captures non-cash income and expenses, and we need to subtract out or add back these items accordingly to find the true cash impact to the company.

 Moreover, just because a company has a positive cash flow position doesn’t mean it is actually paying cash out to its owners. The way we verify whether cash is paid out to owners of partnerships, S-corps or trusts is by reading the K-1 filed with the respective tax return. The K-1 will report the taxable income to the respective owner, as well as any distributions paid or contributions made by that owner.

 Now to put this idea together, a company’s net income is not the same as cash flow, and a company’s cash flow is not automatically distributed to the owner. The K-1 will report what proceeds were distributed to the owner, which may be different than actual cash flow. Many people request K-1s so they may see what cash was distributed, and they will use K-1 distributions to measure cash available for debt service, not the actual cash flow of the company.

 I think this is well-intentioned, but I have an interesting true example that calls into question this practice. Once I had to underwrite a borrower who owned several apartment buildings. Most of her properties failed to achieve break-even cash flow. Even though most properties lost money on an annual basis, she had ample K-1 distributions every year. How was this possible?

 She had owned many properties for a long time, which meant she had a lot of equity in these properties after paying down debt for several years. Each year, she seemed to take out a large new loan against a property with accumulated equity. This loan was not used to renovate the property, but rather used to pay her a cash distribution. Now the old property would have substantially higher debt service and a substantially high cash flow deficit since rents couldn’t be reasonably increased to match the new debt service.

 Each year there was a new loan and a big distribution on the K-1, but effectively larger cash flow deficits on a global level as more leverage was taken on by the sponsor. I had to explain to the lender that even though her K-1 cash flow looked great, the loan was substandard because the actual global cash flow had gotten very bad. Also, she was running out of properties to secure new debt!

 I have come to believe that distributions and contributions from K-1s need to be taken with a grain of salt. A company does not have to be profitable to distribute cash, nor do I think lack of cash distributions should be a sign of poor global cash flow. I think what ultimately matters is the cash flow of the company, not whether the owners chose to pay themselves with the cash flow.

 If a company shows positive cash flow, I think it is cash flow that should be counted towards global debt service, whether or not it is distributed. This is because cash flow is available, regardless of whether or not it is used.  The opposite holds true as well. If a company is experiencing negative cash flow, it should be reflected as a burden, regardless of whether K-1 distributions are made. If distributions are made, they should not be regarded as an available source of cash flow.

 This means instead of collecting K-1s, it makes better sense to collect P&Ls or tax returns to accurately measure global cash flow available for debt service. While this may seem cumbersome to the borrower, I doubt it is any more cumbersome than having to isolate and send just the K-1 from the very same tax return.