Question

In: Accounting

Abe and Brenda formed the AB Partnership ten years ago as a general partnership and have...

Abe and Brenda formed the AB Partnership ten years ago as a general partnership and have been very successful with the business. However, in the current year, economic conditions caused them to lose significant amounts, but they expect the economy and their business to return to profitable operations by next year of the year after. Abe manages the partnership business and works in it full-time. Brenda has a full-time job as an accountant for a $39,000 annual salary, but she also works in the partnership occasionally. She estimates that she spent about 120 hours working in the partnership this year. Abe has a 40% profits interest, a 50% loss interest, and a basis in his partnership interest on December 31 (before considering this year’s operations) of $81,000. Brenda has a 60% profits interest, a 50% loss interest, and a basis of $104,000 on December 31 (before considering this year’s operations). the partnership has no liabilities at December 31. Neither Abe nor Brenda currently has other investments. The AB Partnership incurs the following amounts during the year. Ordinary loss $100,000 Sec 1231 gain 10,000 Tax-exempt municipal bond income 14,000 Long-term capital loss 14,000 Short-term capital loss 136,000 Early next year, the AB Partnership is considering borrowing $100,000 from a local bank to be secured by a mortgage on a building owned by the partnership with $150,000 FMV. Required: Prepare a presentation to be made to Abe and Brenda discussing this matter. Points that should be discussed include: 1.What amounts should Abe and Brenda report on their income tax return for the current year from the AB Partnership? 2.What are their bases in their partnership interests after taking all transactions into effect? 3.What happens to any losses they cannot deduct in the current year? 4.What planning opportunities are presented by the need to borrow money early next year? 5.What planning ideas would you suggest for Brenda?

Solutions

Expert Solution

Abe basis=$81000

Brenda basis=$104000

Calculation of profit and loss for AB partnership:

Ordinary loss = -100000

Section 1231 gain= +10000

Bond income= +14000

LTCL= -14000

STCL= -136000

Total loss = -226000

Abe share in loss =50%

Brenda share in loss=50%

(1)In individual tax returns both will report $113000

(2)Basis in partnership

Abe $81000-$113000= - $32000

Brenda $104000-$113000= -$9000

1. Collateral

As I explained above, banks do lend money to startups. One exception to the rule is that the federal Small Business Administration (SBA) has programs that guarantee some portion of startup costs for new businesses so banks can lend them money with the government, reducing the banks’ risk.

So your business has to have hard assets it can pledge to back up a business loan. Banks look very carefully at these assets to make sure they reduce the risk. For example, when you pledge Accounts Receivable to support a commercial loan, the bank will check the major receivables accounts to make sure those companies are solvent; and they will accept only a portion, often 50 or sometimes 75%, of receivables to back a loan. When you get an inventory loan, the bank will accept only a percentage of the inventory and they will kick a lot of tires first, to make sure it isn’t old and obsolete inventory.

The need for collateral also means that most small business owners have to pledge personal assets, usually house equity, to get a business loan.

See Also: The Complete Guide to SBA Loans

2. Business plan

There are exceptions, but the vast majority of commercial loan applications require a business plan document. Nowadays it can be short—perhaps even a lean business plan—but banks still want that standard summary of company, product, market, team, and financials.

See Also: Introducing Lean Planning: How to Plan Less and Grow Faster

3. All of your business’s financial details

That includes all current and past loans and debts incurred, all bank accounts, investment accounts, credit card accounts, and of course, supporting information including tax ID numbers, addresses, and complete contact information.

4. Complete details on Accounts Receivable

That includes aging, account-by-account information (for checking their credit), and sales and payment history.

(And if you don’t know what your Accounts Receivable are, then count your blessings. If you had any, you’d know. Or, read our guide to find out.)

5. Complete details on Accounts Payable

That includes most of the same information as for Accounts Receivable and, in addition, they’ll want credit references, companies that sell to your business on account that can vouch for your payment behavior. If you need to know more about Accounts Payable, just read our guide that explains things simply.

See Also: Small Business Owners, Start Tracking Your Financial Metrics

6. Complete financial statements, preferably audited or reviewed

The balance sheet has to list all your business assets, liabilities and capital, and the latest balance sheet is the most important. Your Profit and Loss statements should normally go back at least three years, but exceptions can be made, occasionally, if you don’t have enough history, but you do have good credit and assets to pledge as collateral. You’ll also have to supply as much profit and loss history as you have, up to three years back.

Regarding audited statements, having “audited” statements means you’ve paid a few thousand dollars to have a CPA go over them and take some formal responsibility for their accuracy. CPAs get sued over bad audits. The bigger your business, the more likely you’ll have audited statements ready as part of the normal course of business for reasons related to ownership and reporting responsibilities.

Having statements reviewed is a lot cheaper, more like a thousand dollars, because the CPAs who review your statements have way less liability if you got it wrong. Banks won’t always require audited or even reviewed statements because they always require collateral, assets at risk, so they care more about the value of the assets you pledge.

7. All of your personal financial details

This includes social security numbers, net worth, details on assets and liabilities such as your home, vehicles, investment accounts, credit card accounts, auto loans, mortgages, the whole thing.

For businesses with multiple owners, or partnerships, the bank will want financial statements from all of the owners who have significant shares.

And yes, as I implied in the introduction to this article, that’s leading to the personal guarantee. Expect to sign a personal guarantee as part of the loan process.

8. Insurance information

Since it’s all about reducing the risks, banks will often ask newer businesses that depend on the key founders to take out insurance against the deaths of one or more of the founders. And the fine print can direct the payout on death to go to the bank first, to pay off the loan.

9. Copies of past returns

I think this is to prevent multiple sets of books—which I think would be fraud, by the way—but banks want to see the corporate tax returns.

10. Agreement on future ratios

Most commercial loan include what we call loan covenants, in which the company agrees to keep some key ratios—quick ratio, current ratio, debt to equity, for example—within certain defined limits. If your financials fall below those specific levels in the future, then you are technically in default of the loan.

I suggest that Brenda should devote entire time in running operations of the business to run business smoothly.

Did you know this article is part of our Small Business Loan Guide and our Bplans Pitch Guide? Everything you need to know about creating your pitch, all in one place.


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