Loan Officer Training - 11/7/2024 - Analyzing Self-Employed Borrower Income: S-Corporations

Understanding self-employed borrower income can be challenging, especially when it comes to S-Corporations. In this episode of Loan Officer Training, we tackle the complexities of analyzing income for borrowers who operate as S-Corp owners, guiding you through key strategies to confidently assess their financial stability.

Learn how to interpret K-1 forms, identify distributable vs. retained earnings, and accurately assess shareholder wages, all while taking into account the nuances of S-Corporation tax structures. We’ll cover essential documents like the 1120S tax return, Schedule E, and financial statements, providing practical tips on identifying income trends, evaluating debt-to-income ratios, and recognizing red flags in S-Corp financials.

Packed with real-world scenarios, this episode equips you with actionable skills for working with self-employed clients, helping you make informed lending decisions and streamline the approval process. Whether you’re a seasoned loan officer or new to self-employed borrower analysis, tune in to elevate your expertise and close more loans with confidence.

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The Mortgage Calculator is a licensed Mortgage Lender (NMLS #2377459) that specializes in using technology to enable borrowers to access Conventional, FHA, VA, and USDA Programs, as well as thousands of Non-QM mortgage loan program variations using alternative income documentation!

Using The Mortgage Calculator proprietary technology, borrowers can instantly price and quote thousands of mortgage loan programs in just a few clicks. The Mortgage Calculator technology also enables borrowers to instantly complete a full loan application and upload documents to our AI powered software to get qualified in just minutes!

Our team of licensed Mortgage Loan Originators can assist our customers with Conventional, FHA, VA and USDA mortgages as well as acc...

Transcript

Restream recording Nov 07, 2024 • 04:59:25 PM: 0:13

So let's get right into it. So an S corporation is a legal entity with a limited number of stockholders. Now, real important to note here in these key points is stockholders are not personally liable for the debts incurred by the corporation. Um, a corporation has articles of incorporation that are filed with the secretary of state for the state or the entity. The EIN was formed. Please note that, um, other art, um, other, um, documents that you would need when you have an S corporation borrower are the, the EIN letter that they received from the IRS and operating agreement, uh, which will document their percentage of ownership, uh, if you're not going full doc, I mean, if you're going full doc, it's going to be on the K one, right? Uh, and then you have the EIN letter Or see that's how we already covered it and the operating agreement. Yeah. Yeah. And uh, the corporate resolution actually, it's uh, what I meant to say, which at the end is a document that gives them the authorization to transact business for the corporation. If, for example, they're taking title in a corporate entity, for example. So, ANS Corp is a pass through entity, real important point here, where the profit and loss is passed to the individual stockholders according to their percentage of ownership. So I was mentioning the Schedule K 1, uh, that is the document that is used to, um, pass either the, uh, income or loss. to the stockholder according to their proportionate share. So if they're 100 percent owner of the S corp, of the stocks in the S corp, then it's going to show 100 percent on the K 1. If they're 33 percent owner, it's going to show 33%. Keep in mind, uh, that in order to be considered self employed, Uh, the individual has to have at least a 25 percent or greater ownership interest in the S Corp. Less than 25%, they're not considered self employed. So that's a key component because sometimes, uh, as part of quality control, when they're doing the background search, the individual, also known as fraud guard, Um, the S Corp or LLC may come up, uh, linked to the borrower and then you have to provide documentation to show that they're not an owner, that they're not considered self employed. Would be normally, if it's a full doc deal, you're, you're going to provide a K 1. Um, if it's not a full doc deal, you'll probably provide an operating agreement. or something to the effect a letter from the tax preparer as well. Um, so that means that the corporation doesn't pay any of the taxes. The taxes on the income are paid for by the borrower, by the stockholder via the 1040. Please also note now that a borrower may receive W 2 wages from his or her S corp. as a supposed quote unquote employee, right? But they're not really an employee of their own corporation. They just are receiving W 2 income and that because that's the way that they are drawing part of the money from the company, right? They're drawing part of their earnings from the company via W 2 so they can have some payroll taxes and all that kind of good stuff that's associated with that. We're talking about Medicare tax, income tax, stuff that I guess would go towards your retirement, and also their tax strategy, depending on what their accountant has advised. Some may just take it all as retained earnings, and then you see it in their 1099 Schedule C, possibly, or, or just straight up into 1040. But, The important thing to note here is that, um, you know, if they do receive W 2 wages from their S corporation, of which they are at least 25%, or more owner of the stock of the S Corp, then they are considered self employed. They are not an employee and you, you have to follow whatever documentation requirements you need for a self employed borrower and not for a W 2 employee. This has been, uh, has created confusion in the because, you know, we have a borrower turns in pay stubs. Uh, turns in a W 2, uh, the, it's a full doc deal, agency loan gets run through automated underwriting. Let's say we're doing conventional. We get a one year findings for, uh, on AUS and just asking for one year W 2s. 30 days worth of pay stubs, right? Because we have a salaried or, you know, salaried individual, but then a fraud guard comes back or somebody reviews the W 2s or does a check on the company, whatever may happen, that all of a sudden we find out, hey, wait a minute, he's an owner of the company. So now the deal has to get restructured. Uh, we run it through automated underwriting. Now, all of a sudden we don't get the one year findings. We have the two year findings. Uh, the business has only been in business for three years, so we can't go LP for the automatic. If you've been in business five years or greater, only use one year. DU gives it to you if they like the deal, right? If the risk factor is adequate, they're only going to ask for one year. DU doesn't have a. five year rule. I'm talking about DU, we're talking Fannie Mae, LP, Freddie Mac. So in that scenario, now all of a sudden our loan totally changes because now we have to provide two years tax returns and wouldn't you know it, the 22, the 2022 tax return, uh, was abysmal, right? Uh, didn't do that well and now we have to average that really low 2022 with a 2023 and now our income is shot. So just, you know, be aware, uh, when, uh, they are, um, W 2 wages. And all that kind of stuff you, you know, you may want to ask, uh, if, you know, if you see that it's not like a big company or anything like that. So, uh, for the self employed borrower, right, though, that borrower that we've determined that's 25 percent or greater ownership interest in the S corp, uh, the standard is for a two year history of self employment requirement in order to be able to consider the self employment income. Right. That's like the, the standard threshold. However, like with a lot of things in this business, there are some exceptions, I guess, some gray areas that we would call them where you are able to, um, use the income if they have less than two years, uh, full self employment. Uh, one of the exceptions would be if the borrower is receiving same or greater income In a similar field. or position. And the second would be, these are very similar, but it's just a little difference in the wording where one talks about income doing a similar field or position and the other one talks about borrower in a similar occupation in which they had similar responsibilities. So what would be some real, uh, world examples for this, right? And by the way, this is going to be applicable. For full doc type loans going to agency or for example, bank statement loans, right? It's the same concept. You just have to review guidelines, right? This is a generalization of what the guidelines state in agency loans. And then obviously non QM, all the guidelines are going to be different. Some allow for this exception, some don't. So real life examples here would be You have a nurse, right? A nurse has a, typically has a nursing license, some type of certification. This nurse is working as an employee for a doctor. Now the nurse decides to go 1099, right? She formed, uh, maybe she formed an LLC or not, but let's say she's going 1099. She's getting 1099 income. Now she's self employed. She's still a nurse. She still has that nursing license for the nurse. It's, uh, and anybody else that has a license, it's going to be a lot easier because you're linking the experience to the license. Very easily verifiable component, right? Electrician's license, nursing license, doctors, right? Attorney, right? Was working for a firm. Now they have their own firm. So the key component there is going to be either reading the findings. If it's an agency loan, uh, from your automated underwriting submission or reading the guidelines and seeing what they allow typically in the findings that you're going to get in the agency loan. Is that the borrower you're, you're going to need to provide at least 12 months worth of income for that income stream in the last tax return, right? So in other words, if 2023, for example, they were doing it from January 1st. Until December 31st, because they actually started doing that type of job in December 15th, going self employment. Then you would have one year's 12 months actually is what they require worth of income on that tax return You're probably going to be good. They're going to average it out Maybe with the w 2 income that they had or not, depending which is the, the, the bullet point that you're using to, uh, try to get the exception. If you're going with the similar or same or greater income in a similar field of position, you're probably going to average it out. If not, you're looking at the licensing, uh, and obviously you're going to push the averaging out if there was good income right from the W 2. If not, you're going to go with the, hey, let's just use their self employment income now and then let's hope that it's a really good. So, you're, you're seeing how you can get the exception to less than two years in business, uh, and it's really going to be linked to what were they doing previously. There were a similar type of involvement, then there's a very good chance that you're going to get, uh, the exception. Now, for, um, in terms of the income stream. Right now, this is a very important that you follow the paper trail here because this is where, uh, many MLOs make the mistake when they're calculating, they're analyzing and calculating what they need. We get the borrower self employed. All they're giving us is a 1040. Uh, they don't know they got to necessarily give us the 1120s and maybe the MLO didn't ask for the 1120s. If they're, if they have an escort. But or maybe they are saying now here's this is how you can also see that the W2 borrower who says that he's an employee is really. And owner, right? This is where you're going to, this is where your detective work comes into play when you're analyzing the documentation, because first and foremost, the business income, in other words, the profit and loss breakdown of that business, of that S corp is going to be reported on IRS form 1120 S as in Sam, that's an S corp tax return. Every S corp needs a file. By the way, sometimes you're going to see people that have an LLC file and you live in 20 s. They have the LLC for liability reasons and then they're filing. As a single uh, member, LLC, in an SCORP to be able to file their documentation because the 10 65, and this is for another lesson, but the 10 65 is for partnerships. So if you have an LLC, single member LLC and you gonna file a tax return, you're probably gonna have to set up a SCORP and file an 1120 s as well. So, uh, now note the 1120 s breakdown of all the expenses on page one. Right. Page one has the, the, uh, the gross sales or revenue, has all of the expense components. The main expense components are listed there and then you get reference to other statements or pages on that. Um, so that's where you're going to see all of the breakdowns. So, when you're doing your self employment borrower income calculations of an S corp borrower, you need to have the S corp. tax return because that's where you're going to draw items such as depreciation, amortization, depletion, and all those other items like that, that you, plus the income. The main income of the corporate side because on the worksheet, you're going to have that section plus you're going to have the K one section where you're going to document then where each partners share their each partners proportionate share of their income. So if you have three stockholders in that escort, there are thirty three point three, three, three, three percent. Owner each one. So each partner's share is going to be reported on the K one, right? And that's going to say 33. 33 percent owner is going to list the income, the ordinary income on line one, then, uh, you're going to have distributions, usually on line 16, D as in dog, that's very important because in a corporation, the only income that you are really going to count. Is the income that is distributed on 16 D unless the business has liquidity, right? Uh, assets greater than liabilities. Then you can use the stated income on line one, even though they may not have distributed any of that income on box 16 D. That's what the distributions are when they actually physically take the money out of the business and into their possession on a personal basis. basis, right? So, um, so you'll know that it goes from the 1120s. The income is then reported to the each partner on the K 1 and then that amount reported on the K 1, which has the tax ID number of the S Corp, is reported on, on the IRS personal tax return 1040. Schedule E, as in Edward, page two. Now, most people know the Schedule E as the schedule for, uh, real estate, right? Where you have real estate, uh, income and expenses for each of your properties. I think it's like three properties you can put per page on a Schedule E. So you need more than one page if you have more than three properties. And then the final page, The last page of the schedule E in this case, if you have more than one schedule, it wouldn't be page two. It'd be the final page of the schedule. It would be the page that shows any money coming any royalties coming from corporations, partnerships, or other types of entities like that. You're going to see it on there. You're going to see passive income, non passive income, passive loss, non passive loss. You're going to see a tax ID number. You're going to see the name of the entity. And if you see that there, then obviously. Um, that's when you're going to be alerted to that. They may not have provided you a K one. Then obviously you're going to ask him for a K one at that point, and then you're going to confirm their percentage of ownership. And then you're going to ask them for the, uh, tax returns, the 1120 S of the business so that you can properly do your income calculations where then you're going to put on the schedule, a self employed bar income calculator. It's going to have the first line is going to be for W 2 income. That's W 2 income from self employment, not W 2 income from a, uh, a real job they may have outside of the W 2 income from their self employment that some people do have multiple income streams like that. That would be W2 income from their self employment. And if you guys schedule BCRD or any kind of additional income like that, that's from self employment would be on there. Not the one that shows on their regular 1040 from their regular, uh, business activities of like dividends and interests and all that, that is not for that, for the self employment power or income calculations. So then you'll have the section there for the, uh, 1120s section. And. You'll have the section for the K 1, right, uh, on the 1120S section, that's where you're going to capture the expenses, uh, that you're going to write off, but that's on the next page here, so then, just so you know, then from Schedule E, page 2, or depending what page, the last page of the Schedule E, that income then passes, is combined, if it's two or three or four entities on that Schedule E, that income is then combined Into Schedule 1. Notice all these additional schedules and when the borrower only sends you page 1 and 2 of the tax return, you know, they're doing you a disservice here. Uh, so that income then, self employment income, goes to Schedule 1 and then, you know, combined. Income, losses, whatever, all combined into one number in Schedule 1. And then that number from Schedule 1 is transferred to, uh, page 1, line 8 of the 1040. So it's, it's really important that you follow this paper trail so you'll know what documents you are missing. In order to properly calculate the income of your borrower and also to note that if you see a 1040 with a schedule e page 2 and there's a corporate entity on there, now you got to start asking for additional documentation because there's a good possibility that your borrower owns at least 25 percent of something or more and is actually self employed. So I was touching base on the 1120s income and expenses, right? And, uh, basically I want to share right here our key concepts for that because that's another component when you're completing the, um, income and expense worksheet that you need to know what numbers to put in there and what numbers not to put in there. Because the worksheet just tells you, grab the number from line number 31, grab the number from line number 21, from line number 1 of the K1, but it doesn't, you know, you got to know why you're grabbing it, and if you're able to actually use that number, and it boils down to. To a couple of, of, uh, categories here. The first one is non cash expenses. These are expenses that can be added back to the income. So when you're doing the 1120s section of the self employed borrower income calculator, these categories are the ones that typically can be added back, uh, really easily. So the first category is depreciation. It could be either real estate. Uh, or, uh, or chat or a chattel asset like furniture or equipment, mind you, it could be on page one of the 1120s, or it could be also on form 40, uh, form 8825, I believe, which is the depreciation form. Uh, if they don't have it on any depreciation on the first page, look through the whole tax return and see, you may see it in a, in a, in another schedule. Um, that's a great one to add back now. Depletion. Rarely do we find it, but depletion is when a business, uh, uses a natural resource like oil. So depletion is the exhaustion of a natural resource that they need for their business operation. And, uh, the logic here is to allow them to recoup, uh, uh, have less, you know, have credits towards their income so that they can save money. to be able to purchase these natural resources again to continue their business operation. And then a really tricky one is amortization. Now, amortization is not what you typically consider, right? Uh, amortization when, uh, MLO normally hears it, they're thinking, um, the amortization of a loan, right? The principal balance, the paying down of the balance of a loan, right? The amortization. But that's not what we're talking about here. Amortization. would be one time business startup expenses like patents, uh, surveys, uh, building up goodwill, a lot of things like that before the business even, uh, begins operating that you need to invest in. And typically the word that needs to appear in the expense category is Amortization. Now, you may be able to get away with it and it specifically says one time business startup expenses or something like that or business startup expenses and it lists them out. Then you can tell the, uh, the underwriter, hey, listen, um, what they really meant here was amortization. So then you can recapture that expense. and added back to the um, business, uh, to the income, right? Because it's one time business startup expenses that is never going to occur again with that business once the business is up and running. That's why it's considered a non cash expense. Second category here is expenses limited by the IRS. Now these, this category, any expenses in this category are reduced from the income, right? It's a subtraction, not an addition. The logic here is that typically these expenses that are limited by the IRS, that means that the IRS does not allow you to recoup or to charge off 100 percent of that expense. So the logic is that the percentage that you are not allowed to write off. Is the amount that has to be deducted from the income. So, uh, the most popular category for this is meals, meals and entertainment. I believe it's how they call it in this, in the, uh, the tax form. IRS only allows you to deduct 50%. of this amount. So the other 50 percent is reduced from the income. That's, that's how that one works. And I've seen these pretty high amounts, seven, eight, nine, 10, 11, 12, 000 in some tax returns, depending on the type of business that they're in, where they may be thinking a lot of people out to, you know, lunch and dinners and stuff like that. And, uh, the last category here in these very important key concepts, this is a super important one, saved more than one deal for me, is the relationship between recurring and non recurring income. Or loss, right? So first, what do we mean by recurring? Recurring means that that item, whether it's an expense stream or income stream, is expected to continue for at least the next three years. Remember that three year rule, uh, That we have and then non recurring means that it's a one time event that cannot be considered towards income or expenses. So, what are some real world examples here of, of these and really it's more of the non recurring ones are the ones that we really need to consider because we're going to have non recurring income, but especially we're going to have non recurring losses. That's really the one that is going to allow us to save the deal because that loss is reduced from, from gross revenue and it affects your bottom line. So if you can get that loss added back, you could in some cases significantly increase your bottom line. Your net income. So, uh, the non recurring, uh, type examples would be sale of an asset where the business is not in that type of business, right? So let's say you have a business that sells, uh, two of their trucks, right? Some nice, uh, fancy type of vehicles and they, they get 140, 000. For this, this specialized equipment because they're buying the latest generation one, but they're actually in, let's say agriculture. They're not in the, in the business of selling heavy equipment. So that 140, 000 of income would not be able to be used towards income. So that one hopefully is, uh, uh, pretty obvious. Now, the one that could be a little trickier is when you're trying to get that loss. Uh, removed and get it added back. Now, a real, uh, common, two of the most common, um, areas of this would be a casualty loss, right? Like, uh, theft. Fire, hurricane, uh, you know, uh, which caused a loss of business and they had to put in a claim or something like that and, and then, or, or they had, uh, they didn't, you know, there was a big deductible of 50, 000 on the policy before it kicked in. So they wrote off that 50, 000 as a loss. Right, but that's a casualty loss. So that can be added back as long as they provide documentation from the claim and what they paid out and what they didn't pay out and all that kind of very easily obtainable documentation and the other very common, uh, non recurring loss would be a paper loss. that has been carried forward. So a carry forward loss where maybe three years ago they had a big loss in some kind of category that then they are allowed to carry that loss forward for the next maybe five years or the next 10 years, whatever it may be. Uh, then that one would require documentation from the accountant to clearly explain The accounting rule that was used and the type of, you know, what actually was the original loss and that it's a carry forward paper loss, and then you should be able to get that loss, uh, added back to the income, right? In some cases, these carry forward paper losses can be a very significant amount. So. Really important here, these key concepts. This is where I also see, uh, if you got all your documentation and you've overcome that hurdle where you have your 1120s and your 1040, then, you know, the other obstacle is actually, you know, knowing what you're reading. And last but not least, do know that you are, depending on, uh, what time of the year the loan is occurring. If the loan is occurring in the first quarter of the year and the tax returns presented are very recent, right? Like it's March 10th and the tax returns are, um, are from 20, you know, 24 and it's March 10 of 2025, then you're good with just the tax returns. However, once you exceed the first quarter of the year and the tax returns are from prior, now they were, you know, then you're, you're going to have to provide a P& L. Even if you get the tax returns now. on let's say June 10th, dated June 10th. It's not the day they date the tax return because that tax return is for the business activity of 2024, right? So you would still have to provide, or the borrower would have to provide a signed profit and loss statement. For the business, the year to date business activity from January 1st through June 10th or let's say May 31st. We were doing a June 10th loan to document the income of the company to make sure that it is continuing the same. Please note that they're not going to let you add income from a real juicy looking profit and loss, but they will certainly deduct. Income, if the profit and loss shows a lower income than whatever you were showing as the monthly income, depending on if you had a one year or two year findings, whatever you were doing, and your income was calculated, and now you're, you know, at 6, 000, and now the P& L that you've turned in or the borrower provided shows 3, per month, now you got a big problem. Now you have seriously declining income, and we're going to have to get explanations from, from the borrower, from the accountant, as to is this just timing, you know, most of the contracts come in later in the year, are we in the slow season, what's going on that the P& L is showing, uh, such a reduced, keep in mind how P& Ls are to be used. So, uh, I'm going to give it a moment to see if we have any questions. Uh, this is a very, very important, uh, training today on S Corps. Uh, we have the main points here, uh, of guidance to properly analyzing that income, knowing what documentation to ask for, uh, so that you can, not have any obstacles. Okay, so, uh, hopefully it was very clear to everybody because we do not have any questions. So, thank you for joining us, uh, for today's, uh, training. We do look forward to seeing you, uh, next Tuesday. And remember, next week we are going to be analyzing the very tricky C Everybody have a great day. Oh, wait, we got a quick, uh, last minute question here. Any way to work around adding back health insurance tax credit if required to pay it back? Wow, that's a, that's a tricky one. Any way to work around adding back insurance tax credit? I'm not sure if I understand the question. I think they're the question is if you're if you're required to pay it back and you add it back. I'm not really sure if I understand the question. That's not one of the normal categories of expenses that we are able to add back to income. Seems like that's one where we would be looking for an exception. Uh, because, uh, they're required to pay it back. Anyhow, so we're looking to see if we can edit that. I'm not really sure, but I've never encountered that one. Uh, I'd be, uh, interested in getting some, uh, more information on it from the MLO that posed the question. So, do look forward to seeing you all next week, and have a great, uh, holiday weekend.