Back in 2015 FNMA opened a discussion that had long been ignored in the industry in regards to borrowers who get K1 income. For years both FNMA and FHLMC had rules requiring lenders to confirm that income used to qualify from K-1’s lines 1,2,3 and cash flow adjustments was supported by the cash distributions received by the borrowers. Before FNMA made the 2015 changes, I would bet if we took a survey of people involved with approving loans, 90% either were not aware of the “how or why” of distribution of income, or just were told to ignore it and use the K1 income without further thought. In my years in underwriting and auditing I honestly can’t recall ever seeing a QC fail or repurchase demand over a borrower not meeting the old stated guidelines about distributions. So, who could blame us an industry for not paying attention to the rules when they were both not taught and not enforced (for the most part!).
Today this topic is now much more known, but there is still a lot of confusion on the “how” of meeting guidelines to use the K-1 line 1,2,3 + Cash Flow Analysis income. Lets start by reading the question or requirement currently in FNMA guidelines.
FNMA B3-3-2.1-08
If the Schedule K-1 reflects a documented, stable history of receiving cash distributions of income from the business consistent with the level of business income being used to qualify, then no further documentation of access to the income or adequate business liquidity is required.
Ok let’s break down this guideline and the steps to answer it, we will start with FNMA since they better explain this concept in their guidelines.
FNMA B3-3.2.1-08 Income or loss reported on IRS Form 1065 or 1120S K-1 (06/28/2016)
The key to these guidelines is following the step and paying attention to the options FNMA allows to use the income. First confirm the business has stable earnings trends (using the same analysis as a FNMA form 1088 would complete). Second after you know the business is stable, then complete a cash flow analysis such as the 1084 or with a tool like www.blueprintio.wpengine.com offers.
Complete the 1084 and determine the income that your borrower is trying qualify with that comes from the K-1 on lines 1,2,3 plus the cash flow adjustments. Next compare this income to amount of distributions received by the borrower (Distributions are on line 19A for a 1065 and 16D for an 1120S).
This next part is where the underwriter must support one of the options described in Allregs and where most people get confused on the requirements.
Option 1
Based on the example you can use $22,500, per FNMA guidelines since the cash distributions from the business ($24,000) support the level of business income being used to qualify nothing further is needed.
Option 2
If the distributions are less than the calculated income use only the supported $10,000 instead of the $22,500 total. This part is very important, using $10,000 does NOT mean that you use distributions to qualify. What using $10,000 means is that the business can NOT support cash distributions of $22,500 of business income to qualify, but can support $10,000 since that is all the borrower received in cash distributions. If you are going to use $10,000 to qualify then nothing further is needed since we have again meet the guideline that states “cash distributions from the business support the level of business income being used to qualify”.
For both options 1 and 2 it is very important to remember we are not replacing the income determined on K-1 lines 1,2,3 and cash flow adjustments with distributions, distributions are ONLY being used to support the qualifying income. Many people teach the technique of ALWAYS using the lower of the two numbers to qualify which is ACCURATE. There is no time that you would just look at the distributions and use that number without comparing to the standard K-1 adjustments, see table below for examples to follow.
Option 3
FNMA offers a third option when your borrower has K1 income but his K1 shows NO distributions OR the distribution level of income will not get the deal to work (this sentence edited on 07/02/2017). If the borrower business shows it has adequate business liquidity, here is the quote right from the guidelines “But if the Schedule K-1 does not reflect a documented, stable history, then the lender must confirm adequate business liquidity, as discussed below.”
The question you answering here is this, did the business HAVE the funds for distributions and choose NOT to pay out distributions, then you can use your K-1 Lines 1,2,3 + CFA. But if the business did not have the funds to pay out the distributions you cannot use the K-1 Lines 1,2,3 + CFA because the answer is NO the question the guideline is stating “cash distributions from the business support the level of business income being used to qualify”.
The information you need to confirm the question “The business has adequate business liquidity” is found on the business Schedule L for both the 1065 and the 1120S. FNMA provides capital test formulas in their guidelines which we will review in next week’s blog.
Whew…. I know that is a lot of information but if you keep your business income in those three options you will not have an issue at FNMA
A word about FHLMC, the following information is the authors opinion based on 20+ years industry experience and I am very open to debate about this topic.
Before 07/11/2016 FHLMC did have a written requirement about checking a business distributions of income, as of 07/11/2016 they did drop these references and seem to indicate the only time you need to do any “extra” review of business ability to pay is when you are using income OUTSIDE of what the form 91 states to complete. Because the guideline is a bit long to copy here read through FHLMC Allregs 5304.1: Stable monthly income and documentation requirements for self-employed Borrowers (07/11/16) and you can confirm my statements about no references.
BUT FHLMC has posted future guidelines that go in effect on 03/06/2017 and revamp 5304.1. These new guidelines do in fact use many of the same rules and terms that FNMA is now using for K-1 1120S or K-1 1065. Again, this section is long bug if you go to FHLMC Allregs and check under 5304.1 “future revisions” and read down to the new subsection (d) Business and Income Analysis, the information laid out will line up with FNMA current guidelines and my examples above.
To wrap up, this topic was way back in the shadows for years, but now is front and center for your self-employed borrowers who use K1 income from 1065 and K1 income from 1120S to qualify.
SPECIAL ANNOUNCEMENT We will be creating a video explanation this income topic and many more (over 30+ 15 min or less videos) made to show practical examples , supporting guidelines, and our best explanation of the “why behind the what” in our new video teaching library launching in Jan 2017 , keep up with the launch information at our website at www.blueprintio.wpengine.com for more information.
Hi Michael,
I’m have a solo S-Corp. From which I receive $90K after expenses. I pay myself a W-2 salary of $30; with $30K on line 1 of my K-1; and another $30K on line 16d in distributions. I structured the payments this way for the express purpose of having $90K of qualifying income to buy a house (while minimize taxes). Since I received the full $90K, how do I prove this to an underwriter? …Or is it really “either or” regarding line 1 and 16d of the K1? Thanks!
Hello Michael,
Thanks a lot.. For explaining this topic in depth. I have came acrossed many scenarios in which borrower was evolved into more than one businesses and NOT all of them making profit as per K-1. What do you suggest in this case?
Should I deduct the loss of other business entities from the profit making entities?
Deeply Appreciate Your Help.
Hi Michael,
I have an 1120 BWR (not S corp). Can the W2 income be used if the business is not liquid? I realize we cash flow the “notes payable in less than 1 year” and the M&E but if that is offset by depreciation income are we good to go?
Hi Jo
The guidelines require that you must confirm the following before using any self-employed income (including 1120)
A- The business is stable in sales/expense ratio
B- The business is not insolvent (in other words in debt up to their eyeballs)
The numbers you are talking about in the question (M/E – Line 17D – Depreciation) are not how you confirm solvency. You confirm solvency by looking at the SCH L and reviewing the cash available versus the immediate and short term debt owed.
Take a looks at the SCH L and use UberWriter to complete the solvency test and you can get your answer.
Hope that helps!
Hello!!!
FNMA has told me I cannot add back depreciation from business returns when the borrower is <25% owner. Do you know what the rationale is for this? If you are entitled to 5% of profits/loss, and part of net income was a 'paper write off' why wouldn't we be allowed to add that back into their cash flow (at their proportionate share of the expense). I don't understand, the rep couldn't give me logic to support that direction.
Hi Amber
In reality, the owners don’t get to “spend” depreciation money so even adding that back to someone at 25% is sketchy. The funds are tax-deductible because the IRS allows you to “save” that money to replace the items that are depreciating. If you are only 5% owner , if there is deprecation money deducted that means they put it in the savings account to buy future equipment and supplies. It really isn’t likely the 5% owner was given a check on that money that they can use to pay their bills. Remember the key to income review is translating “taxable income” to “Spendable income” and figure out what actual money the borrower could use to pay bills…and depreciation is not realistically one of them.
I know that is not a perfect answer but I hope it helps!
Hi Michael,
We come across many scenarios wherein a rental business there will be only an amount mentioned in line #2 of K-1, there will no distributions and schedule L will be blank. Can we use the income from line#2? Considering the nature of business?
Hi Michael,
We too have many scenarios as mentioned above, rental business where there will only be an amount in line #2 of K-1, no distributions and schedule L will be blank. I couldn’t see where the question was answered as to whether we can use the income from line #2 or not, considering the nature of the business, but I would like to know the answer.
Thank you!
Hi Lori
Any income earned from K-1 lines 1,2,3 and cash flow adjustments must be supported by distributions or a qualified solvency/liquidity test. If the Distribution are blank and the schedule L is blank you will have to have the borrower completed a balance sheet for each tax year you are using to qualify, and then run the solvency test. For example, if you need to use the rental income from 2017/2018 you must get the balance sheet from 2017 and 2018 and check each year to confirm the company was solvent each year.
I know this will be a lot of paperwork but for this type of income, there is not much choice but to request the extra paperwork. Proving the borrower could have or did receive the income is key to a good file.
Hi Michael,
If the owner made profits and reported on the K1 – (line 1) as well as on his personal return. But he didn’t withdraw the income in current tax year – didn’t show contribution on 16D. He left the income in his account and withdrawn it next year. What are your thoughts about this case?
Thank you!
Hi David
Assuming your a working on a conforming loan without distributions you can’t use line 1 income from the K-1. Fannie/Freddie give you these two options to support use of K-1 lines 1,2,3, and cash flow adjustments A) Distribution “in line” with the amount of income reported on those lines OR B) The business passes the solvency test.
In your example if the borrower is holding the money until 2018/2019 (assuming last tax year was 2017) he/she should be able to pass the solvency test.
Hope that helps!
Michael
Michael,
I have a client that has virtually no box 1-3 income, but a large amount of box 5, 6a, 6b, and 18a interest/dividend income. The disributions on 19A a re a very close match to the total numbers from their interest/dividend income. Those boxes also flow to their 1040. There is a strong 2 yr consistancy.
In this scenario, there is not really any box 1-3 income, but I assume we can we can use the 2 yr avg of all of their interest, tax exempt interest, ordinary/qualified dividends since they are on their 1040’s. Form 1084 does not even have a spot for tax exempt interest or qualified dividends.
Your thoughts on using all of the 1040 interest/dividend income?
I have a client that worked for One company then moved to a new company. The first six months he was paid a w-2 income. After a six of months at this company he was made a 1% owner and his salary switched over to K1 income. His ownership is very small and based on what the company advised he is considered a salary employee. We are wanting to know that since the switch to K1 income is less than 2 years will we have an issue using his income. Same line of work for over two years
I’m a business owner who recently had a loan request denied because of treatment of distributions. My accountant and financial advisor said it would be more tax advantageous to take a limited amount of wage (W2) income, and shift more of my income to distributions. So, in 2015 and 2016 I did just that. The company paid my wages as distributions (as I own 50% of the business) rather than just paying through the normal payroll process. My tax returns reflect only the wage income. The business lost money in 2015, but made money in 2016. In both cases though, the K1s reflect less income than I was able to take from the business via distributions. I’m now not able to qualify for a loan (per the lender) because I don’t have enough income. Is there a way to show that this isn’t the case?
Excellent explanation Michael. Thank you!
I had a discussion on this with a few of my co-workers and they all seem to have a different point of view. The question is; If the borrower does not have any distributions and we cannot calculate liquidity can he/she use the cash flow adjustment such as depreciation ONLY as qualifying income?
Hi Annie
My answer to that is no, and here is where I form that opinion from. The guidelines state that the qualifying income must be similar to distributed income. Qualifying income has always been K-1 lines 1,2,3 and cash flow adjustments. They come as one package before the agencies enforced the distribution rules underwriters would complete the 1084 and the K-1 was just as much as the borrower’s income as the % of depreciation that the borrower was the owner. Those numbers were never separated and when submitted where considered the qualifying income. Another reason I form that opinion is FHLMC guidelines now state that UW need to be cautious if the borrower is not 100% of adding on any of the business adjustments as income (depreciation, depletion, etc), we are now required to confirm the borrower would have access or recieve that income since it is not transferred to the 1040’s.
Hope that helps explain my position on the topic!
TO DISTRIBUTE OR NOT TO DISTRIBUTE?
How about blank schedule L, distributions are less than box 1 on k1 1120s. yet they have balance of ordinary income noted as retained income, in the corp and is 100% owner. Seems like that should work to me…however not sure how FNMA/FHLMC would react.
Hi Brian
Actually having “retained income” is proof positive that the borrower may have earned income in the business (showing on K-1 lines 1,2,3) but did not receive the income which is what FNMA and FHLMC require. Keep in mind our job as underwriters is to analyze taxable income into “useable income” for borrowers. In this case, he/she may have been taxed on the income but did not pay out any of the income for some business reason, meaning the borrower cannot use this income to qualify.
Hope that helps!
Thanks
Michael
Hi Michael, 2 questions, please:
1. S Corp-if the balance sheet is blank (Sch L), we are unable to determine the liquidity ratio, how do we get around that? Are there certain guidelines that about when Sch L needs to be completed?
2. I have a borrower that’s a 33% owner of an S Corp and gets a W2; the U/W indicated cannot use Wages because they are unable to determine liquidity ration because Sch L is blank, does this make sense? Is there a wary around this?
Thank you,
Ramon
Hi Michael, excellent information! and I couldn’t agree more than most lenders don’t really understand the concept of K1 income vs. distributions. One question please. Since our borrowers pay taxes on Line 1 of the K1 which was pass through from the S Corp, why can’t we make that argument with Fannie to still use that income?
Hi Ramon
Thank you for the comment! While is is true that what you see on lines 1,2,3 is the basic information on what you will pay taxes on to the IRS , it defiantly does not mean in many cases that is the actual income RECEIVED from the business. Lines 1,2,3 do not take in to account loans or reserves the company needs either pay back or operate for the next year. Since FNMA and FHLMC are aware of the disconnect between these two numbers they now require underwriters to evaluate both to see what the borrower is actually receiving.
Your calculator for 1065 income goes against the guidance in this blog post. As a test case I used an example where the borrower received a distribution well over the ordinary business income on the K-1 the last two years. My understanding is that the usable income should never exceed the ordinary business income even if distributions are higher. However, Uber Writer’s recommended distribution total doesn’t cap the distribution at the K-1 total, it suggests you use the full distribution amount. Am I missing something?
Hi Kurt thanks for the comment
We built and designed the 1120S and the 1065 to compare the K-1 lines 1,2,3 plus cash flow adjustments against the distribution amount. You should see in blue letters the word “recommended” above the answer that is the lower answer (as I showed in the blog), once you see the recommend answer you can then choose the radial button with the income you determine (and we recommend to you) is the correct answer.
I think the part you are seeing different then we programmed Uberwriter to complete is that uberwriter will not “adjust” the distributions to not exceed the K-1’s and cash flow adjustments. The math on the right hand column is RAW (and will be the wrong income if the distributions are HIGHER than K-1 + CFA). That total is there is not a usable income as you correctly stated but we have to display the math to show you an apples to apples comparison of the two totals so uber can determine the “lower off” amount. If we capped the distributions on the math we would always get an “equal” answer in the case of higher distributions than K-1 + CFA totals, and not able to give you guidance on the real answer.
Let me know if that makes sense, if not contact me at our email contactus@uber-writer.com and I will be happy to review with you.
Thanks
Michael
Hi Michael,
I used this income calculation at a previous job in Private Banking, but we were also always told to look at Loans to Members, Loans from Members, and Retained Earnings. Looking at Retained Earnings to see if members can even give themselves distributions. This seems a little like the liquidity solvency test I must say. What are your thoughts on this process?
Hi Joshua
I think the method you are stating will work, but the key is will FNMA/FHLMC accept it. I have used it a few times but this goes to risk appetite for your company!
Thanks
Michael
This is really alarming – I underwrite at a large national bank (one of the top 10 biggest banks in the USA to give you an idea). We have been instructed to analyze the a bit differently than you described. Which makes me wonder how much confusion there is about these new guidelines. I think there is quite a bit for variance that will surface eventually and finally fnma will provide the typical long overdue explanations. For your examples above these are the differences where I work: example 1 : agree with using 22.500 but would still need to show sch L liquidity because you used the business income to credit income. To avoid a liquidity test we would have to use only 15,000 income (in other words, use the distributions up to the ordinary income earned by the business);in option 2, you could use 10k as you described and not need any liquidity test OR we could use the 22,500 as long as schedule L is 1:1 or better liquidity
Hi Kathy
Thank for the response, please keep in mind I am only opening a discussion not regulating policy at all lenders. So in my opinion Kathy finding an article online about discussing an underwriting topic between underwriters should not be alarming, this how ideas are tested and opinions challenged RESPECTFULLY so we can learn from each other and be open to challenging our own thought process. One of the reasons I started this blog was to have an open discussion about UW topics, I honestly feel between underwriters there is too much ‘one upping” going on , and no sharing of ideas or best practices. So if we can keep this to a discussion online here I am happy to dialog with you because this is what I want… a good open discussion! 🙂
You stated you have been instructed to analyze the topic a bit differently and that seems to be the point of making sure a borrower that is using the K-1 income fully (Lines 1,2,and 3) AND shows distributions is also solvent is a requirement at your employer. As a risk manager myself I don’t think that is a bad overlay nor a bad practice, to me it makes sense BUT in my reading of the guidelines I see the following and would like you to comment. FNMA B 3-3.2.01-08 Income or Loss Reported on IRS Form 1065 or IRS Form 1120S, Schedule K-1 (06/28/2016) states the following (see comment below) ….to me it does state clearly that if you get distributions NO further analysis is needed/ and that is why I wrote that in the blog. This is why i have the opinion that the liquidity your referring to at your lender is an fair overlay but not a guideline requirement.
I look forward to your response on this section of guidelines, and I do honestly appreciate your feedback and discussion.
What about when the line 2 shows a loss from multifamily investments and the distribution shows income 10-20k. is additional documentation needed to support the distribution income?
Hi Matt
Distributions are never considered income, they only support the income you want to use. Due to this concept many people now use a “lower of two” method. Based on what your saying the borrowers actual income from line 2 is a negative number, this means you can only remove the loss from the income. Hope that helps!
If the borrower owns 25% or more i would ask for the full business return and credit back depreciation and any amortization. That may put the income positive. If the borrower is less than 25% we would give them the distributions if they could provide a letter from a cpa confirming the business has adequate liquidity to continue making these kids of distributions.
So what would FNMA calculate as borrower income in this scenario:
Ordinary Income =0
Distribution = 10
Depreciation = 30
Liquidity Ratio = 2
My interpretation is 0, but would like confirmation.
Hi Kathy
Thanks for the question, per FNMA guidelines if you add up lines 1,2,3 and add on cash flow adjustments (depreciation) you can use the $0 + $30 you noted above. The reason for that is per FNMA guidelines either the borrower has the distributions to support that income OR the company is solvent. Since you stated the company is solvent I would use the $30 for income.
Thanks!
Michael
Thank You!
Would you use 0 if Liquidity =.5 instead of 2?
Thanks for the message Jill, sorry for the long delay in the response, we read every post on the blog. I would enjoy having you on board, at the moment we are still on the “start up mode” so taking on another employee is something we are working on. We have been looking at a part time assistant (15 hours per week to demo and complete tasks) as we grow, I am hoping we have room for that in January!
We are a small community bank in central PA and have a lot of customers who are paid on K1s vs W2s with minimal ownership in company (many times less than 10%). So they don’t qualify as self employed due to ownership percentages but that is there sole source of income. There is resistance from owners to release partnership returns when borrowers are minority owners so we can’t do the full analysis you describe above. Any suggestions?
Hi Nan
I understand your dilemma, but the agencies do require the underwriter to confirm that the business income used in lines 1,2, and 3 is supported by distributions. This rule applies even if the borrower is under 25% owner, but let me offer a suggestion. It sounds like the challenge you are having is the K-1’s are not showing distributions that support lines 1,2,and 3. Instead of reaching out and asking the business to provide SCH L (which I agree is probably very hard to get) can you get a letter from the business accountant or the borrowers accountant confirm how much in cash distributions the borrower is getting? Please keep in mind those rules I quoted do not apply to the income received as guaranteed payments or W-2 wages from the company. To support this response take a look at FNMA B3-3.1-09: Other Sources of Income (10/24/2016) – Schedule K-1 income, it does show the need for supporting income with distributions.