green legos 6 ns a map to tax return analysis

Green Legos Six Ns and

A Map to Tax Returns

A guide to tax return analysis for bankers.

Training Open-enrollment Onsite OnlineResource Guides Financial Statement Analysis Tax Return Analysis

Linda KeithI help lenders say “Yes” to good loans.

LEGO™ APPROACH

To Tax Return Analysis

Picture a pile of Legos™, most of them green. Build something with them and you’ll have a model of the tax return.

Green Legos represent Recurring Cash Flow

Why do we need green legos?

Taxable income is not necessarily cashflow Cashflow is not necessarily taxable Our job is to find recurring cashflow

Examples of Recurring Cashflow

Wages ◘ Rentals ◘ Capital Gains ◘ Child Support ◘ Business

BLUE Legos represent Noncash items

Why do we need to find and get rid of blue legos?

Noncash items do not impact the borrower’s ability to pay debt.

DepreciationCarryovers

Net Operating LossesK-1 Pass-throughs

Noncash Examples

No one wrote a check for these items!

Yellow Legos representNonrecurring items

Why do we need to find and get rid of yellow legos?

If you are looking for recurring cashflow, income not usually available won’t pay debt. If you are looking for recurring cashflow, expenses they do not usually incur won’t reduce future ability to pay debts.

Capital Gains?Alimony?Contract Receivable?Insurance Proceeds?

Examples of Nonrecurring

Income

Why question marks? These may or may not be recurring. Check.

Lawsuit settlementFlood repairsStart-up costs

NonrecurringExpenses

Look harder for nonrecurring expenses when you are digging for dollars!

Red Legos representRed Flags

Why do we need to find and resolve red legos?If the deal does not make sense or the numbers make you nervous, you could be looking at fraudulent statements or a business getting into trouble.Even if you aren’t worried, you need to recognize what will worry the underwriters or loan review. Get those questions resolved and you have a better chance of making the loan.Or if is not a good loan, move on to the next opportunity!

Inadequate taxesSettlement Fees

Red Flags

If something doesn’t look right, pick up the phone and call the borrower.

Let’s face it, sometimes it is a mystery.

If it is income…• Is it needed to qualify?• Is it needed for best pricing?

If you cannot tell by looking what color the lego is…here is how to decide whether to pursue it.

If yes…• Check other years• Ask borrower

Let’s face it, sometimes it is a mystery.

If it is outgo…• Is an addback needed to qualify?• Is an addback needed for best pricing?

If you cannot tell by looking what color the lego is…here is how to decide whether to pursue it.

If yes…• Check other years• Ask borrower

RecurringCashflow

Use the green lego approach.You’ll start with this…

RecurringCashflow

And end with this…

FOR ANY TAX RETURN

6 Ns From Taxable Income to Cashflow

Some bankers just LOVE the Green Lego Idea.

Others think I must be NUTS! Well, maybe so….

From taxable income to recurring cashflow to pay debt

I long ago learned that there is more than one way to explain the same thing. Comes in handy in my tax return analysis training and webclasses. So let’s try the 6 Ns.

To get to Historical Cashflow

Start with taxable income…

Add nontaxed income

Subtract nondeducted expenses

Add back noncash expenses

To get to Recurring Cashflow

Start with historical cashflow…

Add new income

Subtract nonrecurring income orAdd back nonrecurring expenses

Subtract nondocumented income

Nontaxed income• Child support and Tax-exempt interest• Untaxed portion of social security, pensions, IRAs

Nondeducted expenses/losses• 50% meals and entertainment• Excess capital losses

Noncash expenses• Depreciation, amortization, depletion• Net Operating Losses and Carryovers

New income or expenses• New rental, business contract or job• This could be anything

Nonrecurring income or expenses• Insurance proceeds or legal settlement fees received• Disaster repairs, alimony paid, charitable contributions

Nondocumented income• Child support received, alimony, notes/contracts receivable• This could be any income that you do not need to qualify the borrower

A few examples of each:

CANADA TO MEXICO

The Road Trip Method

Take the direct route.

Which one of these pictures looks like you at work?

Or is it this one?

Imagine you are headed from Vancouver, British Columbia to Tijuana, Mexico and time is short…

You won’t visit the Space Needle, then Yosemite National Park, then the Oregon Coast, Fisherman’s Wharf in San Francisco, back up to the home of the Appaloosa Stallions, on to Hollywood and then to Mexico.

This is more like it!

Start at the top of the return. Work your way down, step by step!

When you get to a line that comes from somewhere else, circle it and trace it to the source. In this case, Schedule B.

Take the detour to Schedule B and review that schedule for adjustments or questions.

I circle the number on page one to show I traced it. Then I circle the total on the supporting schedule to show I checked that it is the same as the number on the front.

When you are done with that schedule, put a checkmark to show you are … then back to page one and continue down the main highway.

Whenever you get interrupted by a phone call or meeting, draw a line where you are. It will be easy to pick it back up after the interruption.

For Historical:• Nontaxed• Nondeducted• Noncash

Recurring… Continue with

• Nonrecurring• New• Nondocumented

Works for Historical or Recurring Cashflow

Start in Canada and

head to Mexico

Find the GREEN Legos

Congratulations

You have successfully completed

Tax Return AnalysisGreen Legos, Six Ns and a Map

Presented by Linda Keith CPA

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