Loan Officer Training - 11/14/2024 - Analyzing Self-Employed Borrower Income: C-Corporations

Self-employed borrowers who own C-Corporations present unique income analysis challenges. In this episode of Loan Officer Training, we dive deep into the intricacies of evaluating income for C-Corp owners, equipping you with the skills needed to interpret complex financials with confidence.

Discover how to navigate corporate tax returns (Form 1120), understand retained earnings, and differentiate between shareholder wages, dividends, and other income sources. We’ll discuss how to evaluate C-Corp profitability, review balance sheets for hidden liabilities, and assess trends in business income that can impact loan eligibility. With practical tips on identifying potential red flags and understanding the implications of corporate structures, this episode will help you make more informed lending decisions.

Whether you’re a seasoned loan officer or expanding your expertise in self-employed income analysis, this episode is packed with actionable insights to help you handle C-Corp borrowers with ease, streamline the underwriting process, and boost your success with self-employed clients. Don't miss this in-depth guide to mastering C-Corp income analysis and adding value to your lending practice!

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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 14, 2024 • 05:02:47 PM: 0:13

So, uh, Let's get right into it here, um, in analyzing self employed borrower income for a C corporation. Excuse me. So, what exactly is a C corporation, right? A C corporation is a legal entity that exists separate from owners who are shareholders, right? They own stock in the company. Um, Um, they do not actually own the company. Uh, therefore, uh, should be noted that stockholders are not personally, personally liable for the debts incurred by the corporation. Please note that there should be articles in the corporation filed with the secretary of state. Profits from the corporation are distributed to shareholders via dividends. Now it could be also that there could be W 2 wages involved, but how those are going to be considered, if it's going to be considered self employment. Or W 2 earnings is going to depend on if the borrower owns 100 percent of the stock, right? That's the only, uh, that's the main point that I wanted to state that is the big difference between an S corp and a C corp. Uh, for a C corp, uh, for, for a C corp borrower, To be considered self employed, the borrower needs to own a hundred percent of the stock of the corporation. And they also need to own a hundred percent of the stock of the corporation in order to use, oops, what happened? Sorry about that. In order to use any. Of the income or to have any losses counted against them, against their income. Now, this is probably the most important point. So let me, and I'll touch base on it a little bit further. But with that being said, please note that again, touching back on the point borrowers who received W 2 income are still considered employees if they own less than 100 percent of the stock, uh, and losses are limited. Okay. To the amount of investment in company stock, right? Now notice, note that right there, right? That's very important points because I've gotten into this, um, discussion in many files where the, um, borrower may own a certain percentage of the stock. Let's say they own at least 25 percent or more. And for an S corporation, 25 percent is the benchmark. Okay. at which a borrower would be considered self employed. But that is not necessarily the case for a C Corp, at least not when you have a Fannie Mae or Freddie Mac or any other agency loan. Now, if it's a non QM loan, I have seen guidelines where 25% of an S Corp or owns 25 percent of the stock of a C Corp is considered self employed, but those were exceptions to the rule, right? I think, uh, and all the deals I've done, I think I ran into one, um, guideline for one investor that had that in the, um, you know, in their guidelines on how to interpret self employment, right? But as for typically, if you look at any of the training and guidance on income, It is going to state that for the income to be able to be used by the bar for the C corpse income to be able to be used by the borrower and for the losses, just as important for the losses to be considered. against the income of the borrower, the losses of the corporation, the borrower has to own 100 percent the stock of the company. And then the other, um, point is going to be that their losses typically are limited to the amount of stock that they own. So trying to attribute all the corporate losses To the borrower, they own a hundred percent of the corporation stock, you know, um, is that usually something that is going to happen? So again, this is the main point to consider when you're reviewing a borrower that has a C corp, ask them if they own a hundred percent of the stock. If they do not own a hundred percent of the stock, then, um, you should be good. Now, how would you, uh, show their ownership? Well, it may be a little tough because it's not always possible to obtain the corporate tax return, the 1120 S. Maybe they would be willing to, uh, to show the 1125 E. Which is the compensation of officers schedule in the 1120s. That's the one that states, you know, how much is their percentage of ownership and what is the distribution that is being given to that borrower. Now, um, please note that typically, uh, if it is, uh, a self employed borrower now, if it's been determined that they do own a hundred percent of the stock, so they would actually be considered self employed. I mean, unless you're submitting your file to that one investor, that is an exception at 25%. But assuming you do have 100 percent and borrow that onto 100 percent of the stock, then, uh, for them to be considered self employed, you would typically need a two year history, right? This is going to be the same as, uh, any other scenario. A couple of exceptions, borrower receiving same or greater income. Thank you. In a similar field or position or borrower in a similar occupation in which they had similar responsibilities. Now, this may be a little bit tougher when you're dealing with a C Corp, as opposed to when you're dealing with a sole proprietor or dealing with an S Corp. But those would be the only way to grant exceptions to the two year rule. Now, as far as the income stream, right, how do we track it? So the income and expenses, in other words, a profit and loss of the true corporation is reported on, on IRS form 1120, which is the corporate tax return. Uh, please note that do not confuse this with the 1120 S as in Sam, which is the S corporation tax return. So for the C corporation, the true corporation, it is simply form 1120 S. So that's where all the profit and loss is reported. And then the distributions are 1125 E. And that is if the gross receipts of the company exceed 500, 000. At that point then, those distributions are dividends on the 1040 Schedule B. That's the, the 1040 is a personal tax return of the borrower, Schedule B. That's where the dividends are reported. So please note that dividends aren't always You know, from stocks, from an investment in the quote unquote, the stock market, but it could be actually where you have a substantial investment in a corporation, uh, to the point that, uh, you know, you're, you, you, you're named on the 1125 E and getting a substantial portion of dividends via distribution. Now, there's two ways that the borrower is going to get income from that corporation. Okay. Um, one way is through, uh, dividend distribution and the other one is through actual W 2 wages. Uh, and now please note that they're considered W 2 wages for an employee if they do, if they own less than 100 percent of the stock of the corporation. And they're considered a distribution if the borrower is 100 percent owner of the stock. Now here we're talking about the W 2 wages. We're not talking about, uh, dividends. District distribution, but actual W two wages, which is just another way to get the money into the borrower's hands. And then also please note that another income document that you that you will need if actually using the Income from or losses from the 1120 Is going to be the year to date profit and loss report whenever We are beyond the first quarter of the year You So after March 31st, that's when the first quarter ends, you are going to be required to provide. And this again is assuming that the 1120 is required, right? Because our borrower is a hundred percent owner of the stock. So if, uh, it's after March, March 31st, you're also going to need a year to date profit and loss report. So if the application, for example, is in, um, May 15th. We'll probably ask for a year to date profit and loss through the end of April, right? So you would have the year to date profit and loss report. You'd have, I guess, uh, the, if this was 2025, right? Or let's say it's 2024 right now and the application is now November, you're definitely going to need the year to date profit and loss report, uh, through October 31st. Uh, 2024 and then you would also need the 2023 tax returns and depending on your findings, if this is an automated underwriting loan and they tell you two years, then you would need 2022 tax returns. As well as 2023 in the year to date profit and loss for 2024. If a U S says you only need one year, then you only need one year. And again, very importantly, this is assuming that, um, we, that the borrower is a hundred percent owner of the stock and we are considering them self employed and we are asking them then for the 1120. Uh, that, uh, for the corporation as well as their 1040 a year to date profit and loss. And if they receive any W 2 wages, obviously we'd need the W 2s, pay stubs, uh, just to confirm, uh, that type of income. But again, if they're 100 percent owner, that's going to be a distribution and it's going to, that W2 wages will be included in the self employed borrower income calculation. So that's either going to be the form 1084, which is the Fannie Mae form or the form 91, which is a Freddie Mac form. Now I will state that a Freddie Mac is a little bit more geared towards self employed borrowers. Uh, we all know how if the business has been in existence for at least five years, Freddie Mac automatically gives you the one year tax return findings versus Fannie Mae is only going to give you that findings if there's low risk in the deal. Um, but one thing you definitely want to note on any of these businesses is, does the business have liquidity? Right. That's the key. Because if there are W 2 earnings and stuff being paid to the borrower and if there are distributions, we want to make sure that, that the business has liquidity to continue to pay. So you would run a liquidity test or our liquidity calculators, but you know, liquidity is basically assets minus liabilities. One of the biggest categories that's going to come into question here. Are mortgages held for more than a year or mortgages held for less than a year? That's another component in the liabilities, because if it's a line of credit that continually renews, we may be able to exclude it, uh, since it is not a long term loan, right? So, but you know, um, the business has liquidity. If assets are greater than liabilities, but before I go on into the next and final slide, I want to remind everybody the key takeaway from this page and probably the key takeaway from this whole presentation is that a C corporation, uh, borrower has to own 100 percent of the stock of the corporation in order to be considered self employed. And they have to own 100 percent of the stock of the corporation in order to be able to use the income or have losses considered against their income. That's the most important takeaway from this whole presentation today, because that's the argument I've used many times when they've, when they get, um, you know, start asking questions on that 1120 tax return. And as long as you can prove that the borrower is not 100 percent owner of the stock, you can usually, you know, Stop them cold in their tracks. So this is similar to the key concepts on the items that can be added back or have to be counted against the borrower. This is the same on an S corp as well as a sole proprietor, right? So we have non cash expenses, which are expenses that are added back to income. So when you're completing your income calculator. Very important to note these items. The income calculator will tell you where to find these on the 1120, on the 1120s, as well as on the Schedule C. So non cash expenses would be items such as depreciation, depletion, Or amortization. And I'll be clear. Amortization does not mean paying down a mortgage in this scenario. Amortization is one time business startup expense, right? Uh, surveys, um, all, all the work that had to be done. Setting up the business, paying accountants, getting patents, copyrights, whatever, uh, it may be the expenses to start up the business because that's what amortization is. One time business startup expenses, depletion, exhaustion of natural resources. We all know what depreciation is. It can either be on real estate or on personal property. Another key concept here is expenses is limited by the IRS. So, uh, the IRS, uh, and specifically the most common one in this category are meals. Now, what do they mean by expensive limited to the IRS? Well, meals, the IRS only lets you deduct 50 percent of the meal, which means, uh, There's another 50 percent floating around out there. That's an actual expense. In the income calculations, you're asked to add that expense back, which will be deducted from the income, right? So the 50 percent that wasn't deducted, um, as a, as an expense will be added as an expense. So if it's 5, 000, then it's 5, 000 to, uh, reduction to the income in the income calculator. And, uh, last category we have here is recurring versus non recurring income or loss. This is a very important category here because, especially on the non recurring loss part. The non recurring income, if it's non recurring income, we know we can't use it, but it's always good to reach out, have the borrower reach out to the accountant and we can reach out to the accountant and find out what type of income was that non recurring income, just to ensure if we can or cannot use it. But what we're really going to focus more on in this category is on the non recurring loss. That's the one that's affecting you as well because it's on there. But the fact of the matter is that is a paper loss, right? The, the, the recurring losses or recurring income when it's recurring is expected to continue for at least the next three years. Right? So we've got that three year rule there. And versus non recurring, which is a one time event that cannot be considered towards income or expenses. Now, what would be some categories on this? Well, we have, for example, the sale of an asset, like a vehicle or equipment, where the business is not in that type of business. We have a casualty loss, Right. Which is like an insurance claim. You had to pay deductible of 5, 000 out of pocket, or maybe insurance didn't cover, or maybe it was theft and it was under the deductible. Whatever is the out of pocket loss on a casualty loss can be written off. Or a, or a paper loss that is carried forward, right? That tends to be the more common ones where five years ago, they had a big loss. And due to some IRS rule, they allow you to spread out the loss over a certain number of years. So as long as we get documentation from the accountant as to what is the nature of this loss, then, uh, we may be able to get that loss excluded, right, which will improve our income and hopefully our DTI. So this is, uh, very important and this is where you would be working with the, uh, borrower and with their accountant for any type of these explanations on the recurring versus non recurring losses. It's several times I've been able to reach out to an accountant, uh, on a, uh, one time loss on a non recurring loss and have been able to get it waived, uh, and have been able to close the loan based on that. Without that, we were over. With that, we are under. So, um, that completes our slides and I wanted to see, I don't see anyone with any question. Okay, I do have a question here. Uh, is an LLC considered a C Corporation? An LLC is just another, uh, entity, but it is not, definitely not considered a C Corporation. I'll have an LLC on next week's training so you could compare. Okay. But the the C Corp is the one that where the borrower is most removed from ownership and the liability of ownership as the name implies, right? It's a legal entity existing separately from its shareholders. All right, so I'm not seeing any additional questions here. I'll give it a minute, uh, because remember, I mean, C Corp, S Corp, sole proprietor. Those are the three entities that we've covered so far. They're all a little bit different and very important to know. Well, no additional questions. So it looks like we are done for today. I do appreciate you all checking out today's training and look forward to seeing you next Tuesday. Have a good, have a good rest of your day.