Overview
S corporations and some LLCs (Limited Liability Companies) have a special way of dealing with profits and losses. Instead of the company itself paying taxes on profits or deducting losses, these figures are passed on to the owners or shareholders. These shareholders then report this income or loss on their personal tax returns. To do this, they use a form called IRS Form 1120S, Schedule K-1 when filing their taxes. This form shows how much of the company’s income or loss they should report based on their ownership percentage. Afterward, this amount goes onto their personal tax forms using IRS Form 1040, Schedule E. If someone owns part of an S corporation or LLC, they might get money from the company in two ways: as wages (like a regular paycheck) or dividends (a share of the profits). They also report their share of the company’s overall income or loss as shown on Schedule K-1.
Evaluating the Business Income
When a person owns 25% or more of a business, the lender has to take a close look at the business’s finances. This is to make sure the business is doing well. The lender checks that the business makes money regularly, its financial health is good, and it is growing or at least maintaining a steady income. If the business isn’t stable or doing well financially, its income can’t be used to help the owner qualify for a loan.
Borrower’s Proportionate Share of Income or Loss
How much of the company’s income or loss belongs to the borrower depends on their share of the company. This percentage is shown on IRS Form 1120S, Schedule K-1. When figuring out if a borrower’s share of business income can help them qualify for a loan, the lender only looks at the borrower’s share. Two main things need to check out for this income to count:
1. The borrower must have actually received their share of the income as shown on Schedule K-1, or
2. The business must have enough money on hand (liquidity) to allow the borrower to take out their share of the profits without hurting the business.
Lenders can decide how they check if the business has enough liquidity. They might use a common calculation like the Quick Ratio or the Current Ratio. The Quick Ratio is used for businesses that don’t depend much on inventory for their income. It compares the company’s liquid assets (excluding inventory) to its short-term liabilities. The Current Ratio might be better for businesses that don’t sell goods, comparing all current assets to current liabilities. A ratio of one or more usually means the business has enough money to support the borrower taking out their share. However, lenders can use other methods to prove liquidity as long as they explain their reasoning.
Adjustments to Business Cash Flow
When figuring out how much money the business really makes, certain items can be added back into the business cash flow. These include depreciation, depletion, amortization, casualty losses, and other non-regular losses. On the other hand, some things need to be subtracted:
– Expenses for travel and meals that can’t be fully deducted,
– Any income that’s not regular,
– All short-term debts due within a year, unless it’s shown these debts are regularly refinanced or the business has enough cash to cover them without issue.
These adjustments help give a clearer picture of how much money the business is actually making, which is important for determining if the borrower’s share of the income can help them qualify for a loan.
References
For more details, visit Analyzing Returns for an S Corporation of the Fannie Mae Selling Guide.