How to Conduct a Tax Return Analysis

Tax return analysis is the evaluation of tax documents to understand the financial situation of an individual or business. Its primary uses include lenders assessing creditworthiness, investors evaluating opportunities, and business owners monitoring financial health. This process provides a deeper look into financial stability than standard financial statements might show.

By examining the forms and schedules submitted to the IRS, an analyst can construct a more accurate picture of cash flow. Tax returns are prepared under penalty of perjury and contain detailed breakdowns of income and expenses. The analysis aims to adjust reported taxable income to reflect the actual cash available to the filer, offering a clearer view of their ability to meet financial obligations.

Core Documents for a Comprehensive Analysis

For an individual, the foundational document is Form 1040, the U.S. Individual Income Tax Return. This form summarizes income from all sources, adjustments, and deductions, acting as a table of contents for an individual’s financial life by pointing to supporting schedules.

Important schedules attached to the Form 1040 provide a more complete picture. Schedule A details itemized deductions like state taxes and mortgage interest, which can offer insight into spending habits. Schedule C, used by sole proprietors, reports business income and expenses, effectively serving as a mini-income statement. Schedule D reports capital gains and losses from asset sales, while Schedule E is for income from rental properties, royalties, partnerships, and S corporations.

For a business, the required forms depend on its legal structure. A C corporation files Form 1120, which provides a detailed look at the company’s operations and includes a balance sheet. S corporations file Form 1120-S and partnerships file Form 1065. These are informational returns for pass-through entities, where profits and losses are passed to the owners’ personal returns rather than being taxed at the business level.

The Schedule K-1 is issued by partnerships and S corporations to each owner, detailing their specific share of the business’s financial items and linking performance to the owner’s return. Another form for both individuals and businesses is Form 4562, Depreciation and Amortization, which is used to claim deductions for the wear and tear on assets.

Key Line Items on Personal Tax Returns

An individual’s earned income is found on line 1 of Form 1040, which reports wages, salaries, and tips. This figure is substantiated by W-2 forms and provides a baseline for regular compensation. Investment income is detailed on lines 2b (taxable interest) and 3b (qualified dividends). These amounts, broken down on Schedule B if they exceed certain thresholds, reflect the individual’s savings and investment portfolio, offering clues about their accumulated wealth.

Income from the sale of assets is reported on line 7 of Form 1040, pulling its total from Schedule D. This schedule provides an accounting of the sale of stocks, real estate, and other capital assets. Analyzing this schedule can reveal whether gains are a one-time event or part of a consistent pattern of trading, which is an important distinction for assessing income reliability.

For individuals with business interests, details are found on supporting schedules. Business activity for a sole proprietor is detailed on Schedule C, while income from rental real estate and pass-through entities is on Schedule E. The net income or loss from these activities flows to line 8 of Form 1040. All income sources are combined to calculate the Adjusted Gross Income (AGI) on line 11, which is an important intermediate figure in financial analysis.

Key Line Items on Business Tax Returns

For a business filing Form 1120, 1120-S, or 1065, the analysis starts with gross receipts or sales on line 1a, the primary indicator of market reach and sales activity. Directly related to revenue is the Cost of Goods Sold (COGS) on line 2, which includes direct costs like raw materials and labor. The difference between gross receipts and COGS yields the gross profit. A high COGS relative to sales can indicate pricing pressure or operational inefficiencies.

An important expense for closely-held companies is officer compensation, reported on Form 1120 and 1120-S. This amount represents salaries paid to top executives, who are often the owners. This figure is scrutinized because it can be a discretionary expense, sometimes set to manage taxable income rather than to reflect market-rate salaries.

Other expense lines provide insight into the company’s financial structure. The interest expense line reveals the cost of debt financing, and a high amount may suggest a heavy debt load. The taxes and licenses line details state and local taxes paid. Depreciation is a non-cash expense that reduces taxable income but does not represent a cash outlay during the period.

After all revenues and expenses are accounted for, the return arrives at the ordinary business income or loss. This is the business’s net income for tax purposes. For a C corporation, this income is subject to corporate income tax, while for pass-through entities, it is passed to the owners via Schedule K-1. This figure serves as the starting point for the cash flow reconciliation.

Performing the Cash Flow Reconciliation

A primary goal of tax return analysis is to determine the true cash flow available, a figure that can be more revealing than taxable income. This process involves a reconciliation that adjusts the net income reported on the tax return for non-cash items and discretionary expenses. The result is a normalized cash flow figure, sometimes called Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA), which provides a clearer picture of operational profitability.

The calculation begins with the net income or ordinary business income from the tax return. The first add-back is interest expense. Adding back interest removes the impact of the company’s financing structure, allowing for an evaluation of core operational profitability independent of its debt load. This makes it easier to compare the business to its peers, which may have different levels of leverage.

Next, income taxes paid are added back to the net income figure. Tax expense is removed to normalize the cash flow, as different tax strategies and jurisdictions can significantly alter a company’s tax burden. This adjustment helps in assessing the pre-tax earnings generated by the business’s operations.

The most common add-backs are depreciation and amortization from Form 4562. These are non-cash expenses, meaning they are accounting conventions for expensing assets over time. Adding these back brings the analysis closer to the actual cash generated by the business, converting the accrual-based net income to a cash-based one.

For S and C corporations, officer compensation is often added back, especially if the officers are also the owners. By adding this back and then subtracting a normalized, market-rate salary, an analyst can get a more accurate view of the business’s true profitability. Similarly, any identified one-time expenses, such as a loss from a lawsuit, should be adjusted to reflect the ongoing, sustainable cash flow. This final adjusted figure can then be combined with an owner’s other income streams to create a global cash flow picture.