Cash Flow Implications of Multiple State Income Tax Returns
When an analyst receives a borrower’s tax return package, there can be a great variety of information provided in said package, some of which has the potential to distract the analyst in their calculation of a borrower’s cash flow. An analyst recently called in to the Bukers Hotline with a question about some information they received in their individual borrower’s tax return package, and whether or not it affected their calculation of the borrower’s cash flow. Their question to us was, “My borrower has two different state income tax returns from the same year – does that require any extra adjustments in calculating their cash flow?” On this week’s newsletter, let’s help the analyst and discuss the cash flow impacts from having multiple state tax returns in the same year.
What Necessitates Multiple State Tax Return Filings?
When someone has two state income tax returns in a single year, it means that they earned some of their income in one state, and another portion of their income in another state during the same tax year. The state income tax returns will separate income and deductions based on how much is attributable to each state. The federal return reports 100% of the borrower’s activity during the year.
Answering the Analyst’s Question
One of the reasons that analysts have been using the Bukers System for decades is that we tell our users exactly which line items to pick up and where to find them to accurately calculate an individual’s cash flow. Because the Federal Form 1040 reports 100% of the borrower’s activity during the year, the vast majority of these line references direct the analyst to the individual borrower’s federal tax return. So, analysts can ignore the split of income and deductions across the multiple state income tax returns, and follow the references provided to calculate the borrower’s cash flow using their federal tax return. That being said, a borrower’s state tax returns are important for one specific reason in our cash flow analysis.
What should analysts pick up from the state income tax returns?
The only thing that analysts pick up from a borrower’s state income tax return, that they otherwise could not pick up from the individual’s federal tax return, is the amount of state income tax paid during the year. As analysts calculate the borrower’s cash flow, they must subtract cash outflows related to taxes paid, including any applicable state taxes. To the extent that there are multiple state income tax returns, analysts should combine the total state income taxes paid during the year to subtract from the borrower’s cash flow. To more directly answer the analyst’s question from the Bukers Hotline, the only adjustment required for them would be to pick up the state taxes paid from each separate state income tax return to accurately account for all cash outflows made by the borrower during the year.
Quick Example to Illustrate the Concept
Johnny B. Fine is a musician who lives in Omaha, Nebraska, on the border between Nebraska and Iowa. He earns a living by performing at venues in the area, mainly frequenting bars and clubs in both Nebraska and Iowa. At the end of the year, he reports the following on his tax returns:
|
Federal Return |
Nebraska State Return |
Iowa State Return |
|---|---|---|
|
Total Cash Inflows: $85,000 |
Total Cash Inflows: $60,000 |
Total Cash Inflows: $25,000 |
|
Total Federal Taxes: $15,000 |
Nebraska State Taxes: $3,000 |
Iowa State Taxes: $1,000 |
To properly calculate the cash flow generated by Johnny during the year, the analyst should include the following adjustments:
| Add: Total cash inflows from federal return | $85,000 | |
| Subtract: Total federal taxes paid | ($15,000) | |
| Subtract: Total state taxes paid | ($4,000) | |
| Total cash flow available to service debt | $66,000 |
There are no additional adjustments required related to the separation of cash inflows reported on each state’s income tax return. We only care, as directed in the Bukers System, about the amounts reported on the federal tax return, and therefore pick up the total of $85,000. From there, we subtract all taxes paid including federal taxes and the state income taxes paid from all applicable state income tax returns.
KEY TAKEAWAY FOR LENDERS
When evaluating a borrower’s repayment capacity, lenders should rely on the federal tax return for total income rather than separately accounting for income reported on multiple state returns. However, state income taxes paid across all applicable states must be included as cash outflows to avoid overstating cash flow available for debt service.
Conclusion
Have you ever wanted to receive real-time support while spreading tax returns and financial statements, like the analyst who brought this question to us? If you are a user of the Bukers software and/or training products, you have access to the Bukers Hotline, where our team of CPAs is standing by, ready to assist your team of analysts. Feel free to give us a call at 503-520-1303 or email us at support@taxanalysis.com.