Here’s a dilemma in small business lending that’s seldom addressed: When loan applications are rejected due to problems with financial documentation, sometimes, the problem isn’t actually with the business’s financials—instead, it’s in the way the financials are interpreted and analyzed. As a result, businesses with the cash flow needed to successfully repay loans may be turned down, despite your sincere desire to help.
Tax return analysis is often at the heart of this problem. The good news? With the right approach and training, you can improve your analysis while making smart lending decisions. Here are proven tips to help.
Tip #1: Start with business structure
Before diving into numbers, take a moment to identify the type of business entity you’re analyzing. This simple step guides your entire review process, because different business structures file different IRS tax forms—and they report financial information differently, too:
- Sole proprietorship: This entity files the Schedule C with Form 1040 and all business income flows directly to the owner’s personal tax return. Look for business income and expenses reported on Schedule C and remember that the owner pays self-employment tax on net profits.
- Partnership: This type files Form 1065 and partners receive K-1 forms showing their share of income, losses, and deductions. The partnership itself doesn’t pay income tax, but partners report their share on personal returns.
- S-Corporation: This type files Form 1120S. Like partnerships, income flows through to owners via K-1 forms. However, owner-employees must receive reasonable compensation as wages, which affects how you evaluate owner benefits.
- C-Corporation: This type files Form 1120. Unlike other structures, C-corps pay corporate income tax on profits. Owner compensation appears as salary expenses and any dividends represent after-tax distributions.
Understanding these differences helps you navigate each return appropriately. For example, when analyzing an LLC taxed as a partnership, you will look for the K-1 distributions rather than searching for traditional salary payments. The business structure also affects tax treatment: C-corporation profits get taxed twice (corporate income tax and shareholder tax on dividends), while other structures offer pass-through taxation. This impacts how owners may minimize reported profits for tax purposes.
Tip #2: Adjust for owner expenses and one-time costs
Small business tax returns often don’t tell the whole story about operational performance, so learning to separate recurring and legitimate business expenses and one-time costs is key.
- Owner-related adjustments
For some small businesses, there may be deductions that reflect crossover between business expenses and personal assets. Common expenses to consider include personal vehicle use reported as a business auto expense and home office deductions. - Identify one-off expenses
One-time expenses can make a business look less profitable than it actually is, so it’s important to understand these expenses when they appear on tax returns. Generally speaking, lenders may add them back when calculating sustainable cash flow.
Example: Bakery-equipment purchase
Consider a bakery that shows unusually low profits one year. Upon closer examination, you discover they purchased $15,000 in new ovens and expensed the entire amount rather than depreciating it. This purchase was necessary for expansion but won’t recur annually. By adding back this one-time expense, you see that the bakery was investing in growth and its true operational profitability becomes clearer.
Other common one-off expenses include:
- Legal fees for business formation or major contracts
- Consulting costs for system implementations
- Repairs from unusual events like storm damage
- Costs related to relocating the business
The key is determining whether these expenses will repeat in future years. Equipment purchases, legal settlements, and moving costs typically don’t recur, making them good candidates for adjustment.
Tip #3: Cross-check against other financial documents
Tax returns represent a single perspective of a business’s financial picture that may include tax strategies to help reduce taxable income. In the process, this may make cash flow look strained, even if it isn’t, so reviewing additional financial documents is important.
- Financial statements
Tax returns may reflect cash-basis accounting, which records income when money changes hands. This timing difference can make profitable businesses appear less so. Reviewing a business’s financial statements can give you a truer picture of cash flow. - Bank records
Compare reported revenue against business bank deposits to gain another view of cash flow. Many small businesses have legitimate reasons for minor discrepancies, such as outstanding checks or deposits in transit; however, significant unexplained differences may warrant additional conversations with the business owner. - Credit report analysis
Personal credit reports often reveal how well business owners manage financial obligations, so a common practice is for lenders to create personal budgets based on credit-report payment obligations, living expenses, and business income. If a business owner can’t support themselves (and their family, if relevant) with business profits, then a loan request may be riskier than the tax returns show.
Conversely, sometimes business owners with excellent credit have temporarily depressed business profits due to tax planning or major investments. Their strong personal financial management suggests a better risk than tax returns indicate.
These proven steps can help you strengthen your institution’s small business lending program and become a better connection between your clients and the capital that helps their small businesses to grow and thrive.
Moving forward: Build better analysis skills
These three strategies—understanding business structures, adjusting for extraordinary items, and cross-checking multiple documents—form the foundation of smart tax return analysis, but it also requires practice and ongoing education.
If you’d like to deepen your expertise, take a look at Grow America’s training programs. They include courses to improve targeted skills like loan analysis, as well as our comprehensive Economic Development Finance Professional series for financial analysis, case study practice, and certification opportunities. In particular, CI330: Advanced Credit Analysis takes a close look at the tax returns analysis process. We’re looking forward to seeing you in the classroom—virtual or in-person!