You see interest income on your borrower's Schedule B. Before you include it in personal cashflow, ask: did they actually receive that cash?
In this installment of our K-1 & Pass-Through Series, Senior Credit Trainers David Stauffacher and Joe Davis tackle a question that came in through Ask the Experts: how should lenders handle pass-through interest income on Schedule B?
Pass-Through Interest Is Not Cash to the Individual
When a pass-through entity earns interest income, the IRS requires the owner to report it on their personal return. It flows through the K-1 and shows up on Schedule B. But in almost all cases, the individual never received that cash.
The same applies to pass-through dividend income on Schedule B and the share of operating income that appears on Schedule E. All of it is passed through for tax purposes, not because cash actually moved to the owner.
As David put it: the individual has to pay tax on it, and that's why it shows up on the return. But the cash stayed in the entity.
The bottom line: Don't include pass-through interest or dividend income in the individual's cashflow.
Where Owners Actually Get Their Cash
So if pass-through income isn't cash, how do owners take money out of their entities? Joe walked through the common channels:
- Wages from the company
- Distributions or withdrawals
- Guaranteed payments (for partnerships)
- Loan repayments if the owner previously loaned money to the entity
These are all real cash inflows for the owner and real cash outflows for the company. They belong in your cashflow analysis. Pass-through items from Schedule B and Schedule E do not.
The Twist: When Schedule B Interest IS Cash
David raised an important nuance. Not all interest income on Schedule B is pass-through. If the owner loaned money to the entity, the entity pays back principal and interest. That interest shows up on Schedule B too, and it IS cash the individual received.
Ideally, the CPA preparing the return will note "from K-1" next to pass-through items on Schedule B. But that's not a requirement. As Joe pointed out, you can't just see interest on Schedule B and assume it's all pass-through. Sometimes you have to do a little digging.
If you spot interest income from the company and it's not clearly marked as K-1 pass-through, check whether there's a note or loan involved. Understanding that distinction can change your cashflow picture.
How It All Washes in Global Cashflow
All of this washes out in a global cashflow analysis. What's a cash outflow for one entity is a cash inflow for another. But as Joe emphasized, it matters where the cash is actually generated. You want to see your primary borrower and primary payment resource clearly, then identify what's secondary or tertiary.
Getting this right at the entity level, even when it nets out globally, gives you a stronger credit narrative and clearer documentation.
Key Takeaways
When you see interest or dividend income on Schedule B, ask one question: is it pass-through from a K-1, or is it cash the borrower actually received?
- Pass-through interest/dividends: Don't include in personal cashflow
- Interest from a loan to the entity: Include it, and document the note
- When in doubt: Check whether the CPA noted the source, and dig into the K-1
