In last weeks blog What you need to know about distributions vs K1 income I reviewed what both FNMA and FHLMC require a seller to confirm too qualify your borrowers income for borrowers with K-1 1065 and K-1 1120S income. I had reviewed “option 3” when your borrower does not show distributions that support the income being used to qualify. As part of using “option 3” to confirm you could use K-1 income, I stated that you must review the business’ schedule L to confirm the business was solvent to use the income. As promised let’s review the acid test or business liquidity test outlined in FNMA B3-3.2.1.08. Please note FHLMC does not lay out the detail of the math like FNMA but does state the following. FHLMC 5304.1 (03/06/17) “In addition, the Seller may calculate and consider the liquidity ratios of the business using generally accepted accounting practices when analyzing the liquidity of the business”. With this statement, it shows that the formulas below can be used for both agencies reasonably.
How To Perform a Solvency Test
First keep in mind, the reason you are completing this solvency test is to document an accurate answer to this question.
“Why does the borrowers K-1 show no distributions”
The solvency test will reveal one of these two answers
A. The business does have the funds to pay, but held onto distributions for a business purpose
B. The business did not have the funds to pay, therefore no distributions were paid.
Of course the outcome we want is option A, options B confirms that the borrower may have had taxable income according to the IRS, but did not have actual income to qualify for a mortgage according to FNMA and FHLMC.
Test 1 – Quick Ratio or Acid Test Ratio
Appropriate for businesses that rely heavily on inventory to generate income. This test excludes inventory from current assets in calculating the proportion of current assets available to meet current liabilities.
First add up the current assets from the schedule L
Cash on Hand 1D + Accounts Receivable 2B(D) +Other current assets 6D
Second add up the current liabilities from the schedule L
Accounts payable 15D (for 1065) OR 16D (for 1120S) +
Mortgage, notes, bonds, payable less than 1 year Line 16D (for 1065) OR 17D (for 1120s) +
Other current liabilities 17D (for 1065) OR 18D (for 1120s) +
(Please note the mortgages notes and bonds payable in less than 1 year can be ignored if you have documented these debts can be “rolled over” year over year.)
Third complete the math by dividing the assets by the liabilities. This is your quick ratio, otherwise known as acid test ratio.
Test 2 – The Current Ratio or Working Capital Ratio
This may be more appropriate for businesses not relying on inventory to generate income.
First add up the current assets from the schedule L
Cash on Hand 1D + Accounts Receivable 2B(D) + Inventory 3D + Other current assets 6D
Second add up the current liabilities from the schedule L
Accounts payable 15D (for 1065) OR 16D (for 1120S) +
Mortgage, notes, bonds, payable less than 1 year Line 16D (for 1065) OR 17D (for 1120s) +
Other current liabilities 17D (for 1065) OR 18D (for 1120s) +
(Please note the mortgages notes and bonds payable in less than 1 year can be ignored if you have documented these debts can be “rolled over” year over year.)
Third complete the math by dividing the assets by the liabilities.
This is a lot to take in! I have often felt as an underwriter I had to have a good understanding of not just mortgage underwriting but accounting and taxes. This information can be overwhelming at first but after you follow the steps above it will become easier.
Good news to help you out! We will be creating a video explanation for this income topic and many more, with over 30 videos that are just 15 min or less. These are created to show practical examples, supporting guidelines, and our best explanation of the “why behind the what” in our new video teaching library. Keep up with the information at our website at www.blueprintio.wpengine.com for more information.
Is there a way to pass the liquidity test when you receive an error because the business has no debts on Sch L? The S-Corp receives income from writing/entertainment and has no long-term debt over monthly expenses. So, the cash/assets would have to be divided by ‘zero’ for the liabilities – which gives an error…
I learned today that IRS Code for SCORP, schedule L, is only required when the sales of scorp exceed $250K and the assets at the end of the year do not exceed $250K.
There has to be other ways to document solvency of the business…thoughts?
Hi Brian
You are right on target, smaller companies that are under a certain volume and assets are not required to fill out SCH L which is a balance sheet. You could try a few options, first, have the borrower go to back to their tax preparer to complete the SCH L. It may not be required by the IRS but that does not mean the borrower can not have one done. Or at a minimum have the tax preparer provide a full balance sheet for 2016 (and 2015 if you are required to get two years income) to analyze. Getting those documents will allow you to complete a solvency test to see if you could use that test in lieu of distributions.
Thanks for the comment
Michael
Very interesting reads michael, i have been battling this all week. Would likecto speak to you if possible
Michael,
I was a commercial loan officer with a bank for 20 years and never saw a K1 like the one which I reviewed lately. The company lost money and the principal’s had to make an infusion of capital to cover operations. My current employer received his K1(from company he has invested in) line 1 of his 1065 and it showed his percent of his loss. His member capital is negative and the entity had no funds on hand available for distribution, however line 19 was showing a cash distribution. Do you have a possible explanation for this. His negative member capital increased with respect to his infusion.
Hi Mitchell
I am no expert on tax filings but what you described is the following. Borrower business lost money, borrowers infused money, borrowers did right off a legitimate loss on K1 line 1 (which should not be connected to capital in any way). Honestly the only thing i can think of on the 19A is that he put money in the business at some point, and the business did not need the “full loan” to survive so it paid him back on 19A. But again that is a best guess!
Thanks for the comment!
Michael
Hi Michael, I have a question. I own and operate a health club for the past 11 years. I have taken the same stable taxed w-2 pay for three years, and my company shows a profit.
However,
I do however like most health clubs have debt on equipment, and this is causing my company to fail the Liquidity test.
I do have accounts receivable that if listed on my balance sheet would cause me to pass, but they are not listed on year end tax return, and in fact my numbers are completely different now than at the end of the year.
So my questions are:
Can my accounts receivable be used on Asset list?
And
Can an up to date Balance sheet be considered in addition to the tax return?
Thank you!
Lesa
Hi Lesa
Thank you for the question… we do not consider all debts on the SCH L against a borrower, there is a sequence of things an underwriter will do to review your income well before going to a solvency (or acid test) to qualify. 1) Does your K-1 show distributions (line 16D on an 1120S or 19A on a 1065) at or around the total of lines 1,2,and 3 on the K-1.. .if yes not solvency test is needed to qualify your business. 2) If the answer is no, at that point we would do a solvency test, the test would be on a 1065 taking SCH L line 1D + 2BD + 6 divided by Line 15-17 1120S SCH L line 1D + 2BD + 6 divided by lines 16-18 . If your result is 1.0 or greater …then your income is also usable without distributions. My advice for business owners, make sure your account is showing distributions on your K-1, there is no reason not to as they don’t affect taxes! Thanks! Michael
Hi, I had a question. I was wondering why we would use 6B in lieu of 6D, being 6B is beginning of year assets that could be converted to cash by the end of the year. Would we be counting that money twice.
The answers is… that was a typo! you are correct it is 6D, thanks for pointing that out! We have updated the blog. I commend you on your knowledge of the forms!
Thanks for reading
Michael!
Mr. Whitbeck,
Would love your feedback on this situation on what would be a very common situation for small biz owners facing the FNMA acid test?
-Borrower owns small retail store
-Store is an LLC
-Borrower is the “sole LLC member”
-Store’s 2016 1120S shows Schedule L Line 1 D shows $12,000 liquid assets (inventory omitted)
-Line 18 D of 2016 Schedule L shows $46,000 owed to Bank on a line of credit
Result :Business fails Acid Test from numbers pulled only from LLC’s Schedule L
**Bank line of credit was made in business name, however, the biz owner /Sole LLC member was required by the commercial bank to sign a personal guarantee on the line of credit. (*This is situation is extremely typical and expected for any small business getting a line of credit)
Core Question Here: Since Biz owner is fully obligated to the LLC’s debt (by signing the personal guarantee) should he not ???? Be allowed to add any and all other of his personal liquid cash assets which he has access to the top line of the Acid test ?? The logic is if he is personally liable for the debt on the bottom of the acid test ration…How could FNMA / Lender / preclude him from adding his own personally held liquid assets onto the top ratio?
If the biz were to ever have any liquidity issues …..Of course, since he is personally obligated for the line of credit, he would turn to his own funds. As a sole owner your debts and assets are always 100% co-mingled. That is the way the commercial biz lender wants it…
I this case, he has aprox. $52k in his personal money market account!
My thinking is his acid test ration is>> (or REALLY should be…)
$12k + $52k = $64k liquid assets
__________________ = 1.39 acid test ratio *passes test*
$46k line of credit debt
Hi Ed
Thanks for the question, I am happy to give my opinion but please note my answer may differ from the UW at your investor and they are the final decision maker. One of the risks you take as a business owner is personal debt obligations, so his business is very similar to raising a teenager. Sometimes when you raise up kids you have to help them along , for example co-signing a debt to build their own credit. Business when they are younger do not have credit, so the owner(s) have to give them a boost to them started by co-signing for credit until the business can get credit on its own.
That being said the borrowers personal assets do not belong to the business so they can not be used to offset any business debts (in the same way if you co-sign for you teenager son/duaghter they do not own the assets you have). Keep in mind if the business goes under the banks/creditors can not legally try to sieze the personal assets, so unless the borrower is willing to give his assets to the business (many people do this, you can see it reflected in line 12a and 12B of the K-1).
The acid test is meant to show you if a business has heavy debt which is a good indicator it will not make it too much longer unless things change, which is why FNMA wants these tests to confirm the reasonably of 3 years forward income.
Just to make sure the reason for your question, the only time with FNMA you need to do a solvency test now is if you are trying to use ordinary income (k-1 lines 1,2, and 3) that is not supported by distributions. (Which says a lot about the business as well…they made taxable income but could not afford to give the owners their payments). Is your borrower in this situation? Also when you were commenting on the cash of the business did you include lines 1D + 2Bd + line 6 to see if they had enough cash?
Hope that helps answer your question!
Not sure why you would ever say this “… Keep in mind if the business goes under the banks/creditors can not legally try to sieze the personal assets,…”
???? All Commercial loans to any closely held non-public company, even concerns with $10-$20 million dollars in revenue, require major stakeholders (more than 10%) to sign in blood as a backstop on the loan.
The is NO SUCH thing as a Bank business loan to a non- public company without personal guarantees….It just does not exist period!!
If a family owned small / medium sized businesses could ever ever even think of borrowing $$ without giving personal guarantees it would be a run-away Wild West.
Michael…if you have any commercial banker friends I would ask you give them a call tomorrow and they will confirm everything I’m telling you.
Kind Regards,
Ed
Hi Ed
I have to respectfully disagree with your points here is my reasoning
1) If you own SCH C business you are wide open to your personal assets to be taken for a business mistake. If you open an LLC, 1065, 1120S, or 1120 for the most part you personal assets are protected UNLESS you did something illegal while acting on behalf of your business OR you pledged your assets to the business. Yes i misspoke there are legal reasons why you would lose money, just FYI I try not to talk in extremes of “Always and Never”, I try to talk in concepts because in most cases you can find things that violate the general rule. Yes you are right there are a minority of cases you can loose personal assets but in an overwhelming majority of cases you can not loose personal assets.
2)Your comment on “NO SUCH thing” as a bank business loan non-public without a personal guarantee. Here is a blog from American Express explaining how to get them, so these seems to contradict your statement! https://www.americanexpress.com/us/small-business/openforum/articles/how-to-secure-business-financing-without-a-personal-guarantee-scott-allen/
Here is a blog from “The Balance” also explaining how to do it. https://www.thebalance.com/personal-guarantee-basics-315207
i could post more examples but I think you understand my position When your read the blog I stated owning a business is like raising a teenager to an adult, sometimes you have to “help out” your business get started, but once your business has its own credit rating it won’t need your personal guarantee.
Thanks for taking the time to read my information, have a great day!
Michael
Michael, thank you for the insight. However, as an underwriter for a big bank, we’re asked to deviate from this approach and simply verify business income remains positive through the 1084 format, Once income is determined, we give the K-1 income with no additional verification of schedule L. As a novice in underwriting, I find your information more inline with what it should be to fully assess business related risk. However, since we sell to Freddie Mac, having read last week’s blog, Freddie Mac will son be bringing their guidelines to par with Fannie Mae. With that said, I might be ahead of the game once released! At least I wont look like a dear in headlights. 🙂 I look forward to your video library!
Thank you for the feedback, I would say there are still a lot of companies / underwriters who just verify income without distributions. I find this is true with many banks who sell to FHLMC, which makes sense because FHLMC has not really commented as much on the business solvency items up until this point. As you mentioned and I agree this might change when they offically launch there 03/06 guidelines. I appreciate the feedback and thank you for following my blogs I am glad they are helpful! Video library is still on track for End of Jan 2017 launch! Thanks!
Thank you for this explanation. I’m missing something though. I don’t understand how a ratio which demonstrates that a business has more assets than liabilities answers FNMA’s requirement that the lender confirm that the business has adequate liquidity to support the withdrawal of the earnings. The ratio determination would only confirm this if the shortfall between the reported income and the distribution where considered in the businesses liabilities. I’d love to see your take on this. Thank you!
Hi Joseph
Actually I don’t feel like your missing something, I have had that same questions myself. For example if your borrower has $25,000 on line 1 of his K-1 and his distributions show $5,000 for the year if you need the full $25,000 to qualify based on $5,000 in distributions you are $20,000 short! So per the guidelines to use the full $25,000 you complete the solvency test as i described in the blog , lets say you have $5,000 in current assets and only $4,000 in current debts. That ratio is 1.25 which is above the 1.0 which FNMA states a business is solvent and would qualify per their guidance to allow use of the full $25,000. This goes back to your question…. why would that fix the borrower not giving him/her self the full $25,000, after all why would $1,000 excess cash over bills outstanding cover $20,000 in missing income? This is where I think each lender has to now take the basic information and evaluate risk and create additional procedures, personally I have my opionion on a few suggestions. Add in the “missing” income to the current debts and see if the business could pay it then. Or read the capital account and see if the funds to cover the missing distributions are in the capital account to cover. But I have to go back to FNMA guidelines that don’t specifically require any more “checks and balance’s” and leave it up to the risk department at each lender to decide what is acceptable.
Great Question Joseph, you and I agree that the guidelines leave some question as to if the method described in FNMA Allreges would in fact cover the missing income on the K-1s.
Thanks!
Michael
Maybe you can clarify…the only difference between the Quick Ratio and the Current Ratio looks to be on the asset side, where the Current Ratios allows the use of inventories as an asset. Since the Current Ratio has the potential to give more assets in the calculation (always), and each ratio uses the exact same liability calculation ….why would you not always try to include inventories (if available)? In short, wouldn’t the current ratio be the preferred ratio to give the borrower the best chance to qualify? Thank you.
Inventory is not cash, so you don’t want to assume the borrower can sell the inventory. For instance if the business is a party store it is not realistic to assume the borrower can sell every last piece of gum and lighter in the place to get all that cash back in inventory. Or if the businesss manufactures anything, they will have a good amount of money in inventory (IE a car repair shop could have millions of dollars in inventory). If your borrowers business is not inventory dependent that is why FNMA allows the “add back” … but to be honest I would not use it because it will fall on you to prove the business is not inventory driven.
Hope that helps!
Michael
I think the industry as whole is still struggling to fully comprehend this “new” requirement. Your insights are explained very well in easy to grasp terms. Thank you!
Thank you Dan,
After looking through dozens of these loans in the last few months I tried to create a process that meets compliance to guidelines and creates an efficient “path” to a yes or no on the borrowers loan.
I appreciate your feedback!
Michael
I so look forward to you commentary as it states things in plain English so thank you
DEB
Thank you Debbie, I am glad these are helpful!
Michael