Business owners often change their business entity type as their enterprise evolves. For example, a business may start as a sole proprietorship or single-member LLC filing IRS Schedule C, but later transition to an S-corporation to take advantage of tax benefits.

This change raises important questions for underwriters and processors: Is this still the same business, and does the borrower remain qualified?

Why business tax filing changes matter

When reviewing a borrower’s loan application, confirming how long their business has been in existence is critical. Since most businesses fail within the first five years, this information is a key risk indicator.

When tax forms change, the underwriter must ask: Is this a new business, or did the existing business simply change its tax filing status? The answer will significantly impact the borrower’s loan qualification.

How to determine qualification 

Confirm whether the business is new or has simply changed tax filing status.

The first step is determining if the borrower has been operating the same business for two years or more. It’s important to avoid confusion with the guideline requiring two years of self-employment income. The guideline specifically refers to two years of income from the same business.

For example: If a business started in 2018 as a Schedule C entity and converted to an 1120S in 2023, it is considered five years old. This demonstrates the borrower’s consistency in managing the business, which is vastly different from a new business with no track record.

Key ways to confirm this include:

• EIN Match: The Employer Identification Number (EIN) is unique to each business and cannot be transferred. If the EIN matches, it’s the same business.
• Business Type and Address: Match the business type (IRS code) and address to verify continuity.
• Letter of Explanation (LOE): If necessary, request an LOE from the borrower confirming the change was solely a tax filing adjustment.

Handling Ownership Changes

As of 2024, FHLMC guideline 5304.1 introduces a new requirement: If a business changes its ownership structure—such as adding owners or altering the borrower’s percentage ownership—it may be considered a new business, regardless of EIN or other factors.

How to Determine Income

Review the borrower’s income for each tax year based on the business entity’s filing type. For example, if the current tax year uses an 1120S form and the prior year uses a Schedule C, calculate income using standard guidelines for each respective form.  You will have an annual income for the 1120S and an annual income for the Schedule C.

Calculate Final Income

After determining income for each year, follow standard income trending rules to finalize qualified income:

• If income is increasing: Use a two-year average.
• If income is stable or declining: Use the most recent year’s income

A decline of no more than 10% is recommended.  A decline greater than 10% would require a LOE and supporting documents.

Summary

In most cases, a borrower changing their business’s tax filing type does not disqualify them from obtaining a loan. The primary concern is income stability.

Borrowers who run a business inherently pose different risks compared to those who work for a company. As a processor or underwriter, understanding these nuances is key to evaluating a borrower’s financial stability effectively.

Guideline References

FNMA B3 3. 2-02 Business structures

FHLMC 5304.1  Stable monthly income documentation