Over the years we have done a few articles on how to determine the proper income for 1065 and 1120S borrowers. Some people nickname these borrowers “K-1” borrowers. As an industry we are getting used to the change from Fannie Mae and Freddie Mac that require us to now consider the distribution amount to support the K-1 income.
I can remember that rule in place for a least 10 years before there was any enforcement on it. Terms like “stable and solvent” for self-employed borrowers have come out of the dark and is now discussed on a regular basis. To be honest with you if you asked me in 2014 what is a solvency test, I would not have known the answer, even though I had been underwriting for over 15 years.
So that leads me to publish the question that appears most in our inbox for UberWriter.
“Why can’t we use the distribution amount if it is higher than K-1’s Lines 1,2, and 3”
One of the first things to understand is just because the K-1 lines 1,2, and 3 say you earned income….does not mean you received that income. You could have received more or less than the amount on lines 1,2, and 3. As a side note, W-2 income and guaranteed payments (K-1 Line 4 of the 1065) are NOT affected by this topic. For those incomes what you see is what you get!
Why would the distributions be more than the K-1 amounts?
Here are two main reasons:
When you run a business, you are the primary person (or persons) that have to grow that business. Part of growing the business is investing in that business in the form of cash reserves. A good business plan calls for keeping “cash on hand” just in case the business sees a drop in sales or needs to make an investment to grow. So the money in my company savings account which was earned in the past and taxed in the past can now be paid out in the present without taxes (as a distribution).
Another way to explain that same topic is if you had an employed borrower who earned $50,000 per year on a W-2. They also disclosed they took out $20,000 from a savings account to pay or a kitchen remodel. Would that borrower’s income be $70,000 per year or $50,000? Of course, the answer is $50,000, we would not money saved from the past as part of this year’s income.
The second main reason is repayment of capital paid to the borrower. Let’s say a business is 3 years old, and your borrower gave this business $25,000 from their savings account to the business as startup capital. The business would not record a loan as income when it was received in 2015, and it will not be able to deduct it as an expense on the 2018. BUT the member/partner who paid it can receive it back as part of the distributions. Remember the money loaned was earned and taxed in the past, so it is not re-taxed again when it is repaid. The funds are simply paid back and the partner put its back in their savings account.
There are a few other reasons, but the bottom line is in no case do you use Distributions as the income amount for Freddie / Fannie loans. The Distributions are only to support the income shown on K-1 not boost them.
Lesser Than Method
The best method is to follow the “Lesser Than” method. This is where you compare the amount of the K-1 lines 1,2,3 and business cash flow adjustments against the K-1 distributions. Which ever number is less use that in your income calculation. This is how UberWriter was designed. UberWiter will look at the calculations both ways and provide the recommendation based on agency guidelines.
Questions, comments, and disagreements are always welcome! Drop us a message anytime, we hope this K-1 Distribution discussion has been helpful!