One of the main reasons we built the UberWriter income analysis tool was to help borrowers with complex income, which usually means self-employed. Changing tax filing types can throw a curve ball to most loans. Self-employed borrowers are challenging, however, sometimes you are offered the opportunity to help a potential client get the loan others would have declined!
A question came into our email box recently that is the basis for this post. I have not been able to find any other information online to help answer the question. Here was the question… “My borrower filed a schedule C business in previous years, but last year filed an 1120S, how do I calculate that income?” It was followed up with a second question of “Does this affect my borrower’s ability to qualify under the self-employment rules for Fannie Mae and Freddie Mac?”
Will my borrower meet the history requirement for self-employment?
Let’s start off with the second question first, the guidelines recommend that a borrower have a minimum of a two-year history of self-employment to qualify. What tax form the client has decided to use does not affect the “history of self-employment section” of the guidelines. If the business started in 2010 as a Schedule C and converted to an 1120 S in 2017 the business is considered seven years old and should be entered as such on the 1003. The bottom line is the borrower has a business and has shown success in running and maintaining their business, this shows stability in income and this is really what we are analyzing to approve a loan.
Why would we want to convert the income?
Back to the first question of how you calculate the income. The main reason you want to convert one tax form to another is, every income tool out there has two to three years for each tax form type, but the forms do not allow you to choose a different type for each year. For example, a Schedule C for 2016 income and 1065 for 2017 income.
Another major benefit of converting the income to one type is, it will allow you a much better view of the key metrics you are required to analyze for a self-employed borrower. For example, the 1088 review will be easier to look at a side by side converting a Schedule C to “fit” into the 1065 1088 form.
Apples to Apples Math
If you work with self-employed borrowers quite a bit, you will eventually run across this situation. In almost all cases the reason for the filing change is the growth of the company. For example, it is very common to see a Schedule C convert to an 1120S when they become more profitable. Owners do this to maximize their tax savings and create more opportunity for growth in the future.
So here is the main point to keep in mind… Compare Apples to Apples! What I mean is the guidelines are not written with tax form line numbers such as, “add line 12 to schedule C line 31 to determine the income”. The guidelines just state “it is allowable to add back depreciation to the borrower’s income”. When you are converting the borrowers’ income type don’t worry about the tax line number, look for the allowable type of adjustment, or in other words “Apples to Apples” Below I have created a chart to help you match the allowable income and cash flow adjustments between tax types.
Chart to covert a schedule C underwriting income analysis to a form 1065 or 1120S
[fusion_table]
| Schedule C | 1065 | 1120 S |
|---|---|---|
| Line 31 Net Profit | K-1 Line 1 Ordinary Income | K-1 Line 1 Ordinary Income |
| Line 30 Biz Use of Home | K-1 Line 1 Ordinary Income | K-1 Line 1 Ordinary Income |
| Line 6 Other Income | 1065 Line 7 Other Income | 1120S Line 5 Other Income |
| Line 12 Depletion | 1065 Line 17 Depletion | 1120S Line 15 Depletion |
| Line 13 Depreciation | 1065 Line 16C Depreciation | 1120S Line 14 Depreciation |
| Line 24B Meals/ Entertainment | 1065 SCH M-1 4B Travel/Entertainment | 1120S SCH M-1 3B Travel/Entertainment |
[/fusion_table]
Footnote the qualifying income when you convert Schedule C to the 1065/1120S calculators. Per agency guidelines Schedule C income is considered “fully distributed” to the borrower. So whatever the total income is from Line 31 and all of the other cash flow adjustment is the amount of income you use for that year.
That wraps it up today, just keep the concept of “Apples To Apples “ and you will get it! Check out our website for other questions on underwriting with many more helpful blogs like this, our Free version of UberWriter income analysis software, and other teaching resources. If you have not checked out UberWriter, there is no reason to wait, start using it today to calculate any borrowers income!
3 Responses
This is GREAT…I have come across this scenario several times…I did what you show above but with a penalty to my borrowers…I never added back other expense items like Amortization – I wanted to err on the side of caution and have been consistent with this…that should be okay, right?
If a client was Schedule C 2-years ago and switched to 1120S the past year, is there a way to count the W2 wages he paid himself as part of the business income in the 2-year average? Like since he’s no longer paying wages and just taking distributions as an S Corp, the wages paid as a sole proprietor were derived from the same business. It wouldn’t make sense to simply disregard that income in qualifying simply because he’s no longer paying himself wages out of the business income.
Thank you for such a great site and for your help.
Hi Russell
When you say “last year” I will make the assumption that that means 2017 (the year the borrower converted to an 1120S) and also assuming the schedule c was filed in 2016. That being said choose the 1120S calculator in UberWriter and complete the following. In 2016 this is how you convert SCH C to 1120S… Set the 1120S ownership to 100% … Line 31 goes to W-2 Wages the rest of the items line up.. all other items line up by name. For example deprecation schedule C goes to decpreication on 1120S. Hope that helps!