November 7, 2024 • 33 mins
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 over 5,000 Non-QM mortgage loan programs using alternative income documentation!
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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...
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Transcript
Episode Transcript
Available transcripts are automatically generated. Complete accuracy is not guaranteed.
Restream recording Nov 07, 2 (00:00):
So let's get right into it.
So an S corporation is a legalentity with a limited number of
stockholders.
Now, real important to note herein these key points is
stockholders are not personallyliable for the debts incurred by
(00:21):
the corporation.
Um, a corporation has articlesof incorporation that are filed
with the secretary of state forthe 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 anS corporation borrower are the,
(00:45):
the EIN letter that theyreceived from the IRS and
operating agreement, uh, whichwill document their percentage
of ownership, uh, if you're notgoing full doc, I mean, if
you're going full doc, it'sgoing to be on the K one, right?
Uh, and then you have the EINletter Or see that's how we
(01:05):
already covered it and theoperating agreement.
Yeah.
Yeah.
And uh, the corporate resolutionactually, it's uh, what I meant
to say, which at the end is adocument that gives them the
authorization to transactbusiness for the corporation.
If, for example, they're takingtitle in a corporate entity, for
example.
So, ANS Corp is a pass throughentity, real important point
(01:32):
here, where the profit and lossis passed to the individual
stockholders according to theirpercentage of ownership.
So I was mentioning the ScheduleK 1, uh, that is the document
that is used to, um, pass eitherthe, uh, income or loss.
(01:55):
to the stockholder according totheir proportionate share.
So if they're 100 percent ownerof the S corp, of the stocks in
the S corp, then it's going toshow 100 percent on the K 1.
If they're 33 percent owner,it's going to show 33%.
Keep in mind, uh, that in orderto be considered self employed,
(02:19):
Uh, the individual has to haveat least a 25 percent or greater
ownership interest in the SCorp.
Less than 25%, they're notconsidered self employed.
So that's a key componentbecause sometimes, uh, as part
of quality control, when they'redoing the background search, the
(02:39):
individual, also known as fraudguard, Um, the S Corp or LLC may
come up, uh, linked to theborrower and then you have to
provide documentation to showthat they're not an owner, that
they're not considered selfemployed.
Would be normally, if it's afull doc deal, you're, you're
going to provide a K 1.
(02:59):
Um, if it's not a full doc deal,you'll probably provide an
operating agreement.
or something to the effect aletter from the tax preparer as
well.
Um, so that means that thecorporation doesn't pay any of
the taxes.
The taxes on the income are paidfor by the borrower, by the
(03:22):
stockholder via the 1040.
Please also note now that aborrower may receive W 2 wages
from his or her S corp.
as a supposed quote unquoteemployee, right?
But they're not really anemployee of their own
(03:44):
corporation.
They just are receiving W 2income and that because that's
the way that they are drawingpart of the money from the
company, right?
They're drawing part of theirearnings from the company via W
2 so they can have some payrolltaxes and all that kind of good
stuff that's associated withthat.
We're talking about Medicaretax, income tax, stuff that I
(04:08):
guess would go towards yourretirement, and also their tax
strategy, depending on whattheir accountant has advised.
Some may just take it all asretained earnings, and then you
see it in their 1099 Schedule C,possibly, or, or just straight
up into 1040.
But, The important thing to notehere is that, um, you know, if
(04:32):
they do receive W 2 wages fromtheir S corporation, of which
they are at least 25%, or moreowner of the stock of the S
Corp, then they are consideredself employed.
They are not an employee andyou, you have to follow whatever
documentation requirements youneed for a self employed
(04:55):
borrower and not for a W 2employee.
This has been, uh, has createdconfusion in the because, you
know, we have a borrower turnsin pay stubs.
Uh, turns in a W 2, uh, the,it's a full doc deal, agency
loan gets run through automatedunderwriting.
(05:17):
Let's say we're doingconventional.
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 comesback or somebody reviews the W
(05:40):
2s or does a check on thecompany, whatever may happen,
that all of a sudden we findout, hey, wait a minute, he's an
owner of the company.
So now the deal has to getrestructured.
Uh, we run it through automatedunderwriting.
Now, all of a sudden we don'tget the one year findings.
We have the two year findings.
Uh, the business has only beenin business for three years, so
(06:00):
we can't go LP for theautomatic.
If you've been in business fiveyears or greater, only use one
year.
DU gives it to you if they likethe 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'retalking Fannie Mae, LP, Freddie
Mac.
So in that scenario, now all ofa sudden our loan totally
(06:22):
changes because now we have toprovide two years tax returns
and wouldn't you know it, the22, the 2022 tax return, uh, was
abysmal, right?
Uh, didn't do that well and nowwe have to average that really
low 2022 with a 2023 and now ourincome is shot.
(06:45):
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 seethat it's not like a big company
or anything like that.
So, uh, for the self employedborrower, right, though, that
(07:07):
borrower that we've determinedthat's 25 percent or greater
ownership interest in the Scorp, uh, the standard is for a
two year history of selfemployment requirement in order
to be able to consider the selfemployment income.
Right.
That's like the, the standardthreshold.
However, like with a lot ofthings in this business, there
(07:31):
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, fullself employment.
Uh, one of the exceptions wouldbe if the borrower is receiving
same or greater income In asimilar field.
(07:54):
or position.
And the second would be, theseare very similar, but it's just
a little difference in thewording where one talks about
income doing a similar field orposition and the other one talks
about borrower in a similaroccupation in which they had
similar responsibilities.
So what would be some real, uh,world examples for this, right?
(08:19):
And by the way, this is going tobe applicable.
For full doc type loans going toagency or for example, bank
statement loans, right?
It's the same concept.
You just have to reviewguidelines, right?
This is a generalization of whatthe guidelines state in agency
loans.
And then obviously non QM, allthe guidelines are going to be
(08:41):
different.
Some allow for this exception,some don't.
So real life examples here wouldbe You have a nurse, right?
A nurse has a, typically has anursing license, some type of
certification.
This nurse is working as anemployee for a doctor.
(09:01):
Now the nurse decides to go1099, right?
She formed, uh, maybe she formedan 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 nursinglicense for the nurse.
It's, uh, and anybody else thathas a license, it's going to be
(09:23):
a lot easier because you'relinking the experience to the
license.
Very easily verifiablecomponent, right?
Electrician's license, nursinglicense, doctors, right?
Attorney, right?
Was working for a firm.
Now they have their own firm.
So the key component there isgoing to be either reading the
(09:46):
findings.
If it's an agency loan, uh, fromyour automated underwriting
submission or reading theguidelines and seeing what they
allow typically in the findingsthat 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 ofincome for that income stream in
(10:11):
the last tax return, right?
So in other words, if 2023, forexample, they were doing it from
January 1st.
Until December 31st, becausethey actually started doing that
type of job in December 15th,going self employment.
Then you would have one year's12 months actually is what they
(10:33):
require worth of income on thattax return You're probably going
to be good.
They're going to average it outMaybe with the w 2 income that
they had or not, depending whichis the, the, the bullet point
that you're using to, uh, try toget the exception.
If you're going with the similaror same or greater income in a
(10:53):
similar field of position,you're probably going to average
it out.
If not, you're looking at thelicensing, uh, and obviously
you're going to push theaveraging out if there was good
income right from the W 2.
If not, you're going to go withthe, hey, let's just use their
self employment income now andthen let's hope that it's a
really good.
So, you're, you're seeing howyou can get the exception to
(11:15):
less than two years in business,uh, and it's really going to be
linked to what were they doingpreviously.
There were a similar type ofinvolvement, then there's a very
good chance that you're going toget, uh, the exception.
Now, for, um, in terms of theincome stream.
(11:36):
Right now, this is a veryimportant that you follow the
paper trail here because this iswhere, uh, many MLOs make the
mistake when they'recalculating, they're analyzing
and calculating what they need.
We get the borrower selfemployed.
All they're giving us is a 1040.
Uh, they don't know they got tonecessarily give us the 1120s
(12:00):
and maybe the MLO didn't ask forthe 1120s.
If they're, if they have anescort.
But or maybe they are saying nowhere's this is how you can also
see that the W2 borrower whosays that he's an employee is
really.
And owner, right?
(12:20):
This is where you're going to,this is where your detective
work comes into play when you'reanalyzing the documentation,
because first and foremost, thebusiness income, in other words,
the profit and loss breakdown ofthat business, of that S corp is
going to be reported on IRS form1120 S as in Sam, that's an S
(12:41):
corp tax return.
Every S corp needs a file.
By the way, sometimes you'regoing to see people that have an
LLC file and you live in 20 s.
They have the LLC for liabilityreasons and then they're filing.
As a single uh, member, LLC, inan SCORP to be able to file
(13:01):
their documentation because the10 65, and this is for another
lesson, but the 10 65 is forpartnerships.
So if you have an LLC, singlemember LLC and you gonna file a
tax return, you're probablygonna have to set up a SCORP and
file an 1120 s as well.
So, uh, now note the 1120 sbreakdown of all the expenses on
(13:24):
page one.
Right.
Page one has the, the, uh, thegross sales or revenue, has all
of the expense components.
The main expense components arelisted there and then you get
reference to other statements orpages on that.
Um, so that's where you're goingto see all of the breakdowns.
So, when you're doing your selfemployment borrower income
(13:45):
calculations of an S corpborrower, you need to have the S
corp.
tax return because that's whereyou're going to draw items such
as depreciation, amortization,depletion, and all those other
items like that, that you, plusthe income.
The main income of the corporateside because on the worksheet,
(14:07):
you're going to have thatsection plus you're going to
have the K one section whereyou're going to document then
where each partners share theireach partners proportionate
share of their income.
So if you have threestockholders in that escort,
there are thirty three pointthree, three, three, three
percent.
Owner each one.
(14:28):
So each partner's share is goingto be reported on the K one,
right?
And that's going to say 33.
33 percent owner is going tolist the income, the ordinary
income on line one, then, uh,you're going to have
distributions, usually on line16, D as in dog, that's very
important because in acorporation, the only income
(14:50):
that you are really going tocount.
Is the income that isdistributed on 16 D unless the
business has liquidity, right?
Uh, assets greater thanliabilities.
Then you can use the statedincome on line one, even though
they may not have distributedany of that income on box 16 D.
(15:14):
That's what the distributionsare when they actually
physically take the money out ofthe business and into their
possession on a personal basis.
basis, right?
So, um, so you'll know that itgoes from the 1120s.
The income is then reported tothe each partner on the K 1 and
(15:36):
then that amount reported on theK 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, pagetwo.
Now, most people know theSchedule E as the schedule for,
(15:57):
uh, real estate, right?
Where you have real estate, uh,income and expenses for each of
your properties.
I think it's like threeproperties you can put per page
on a Schedule E.
So you need more than one pageif you have more than three
properties.
And then the final page, Thelast page of the schedule E in
this case, if you have more thanone schedule, it wouldn't be
page two.
It'd be the final page of theschedule.
(16:18):
It would be the page that showsany 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 passiveincome, non passive income,
passive loss, non passive loss.
You're going to see a tax IDnumber.
You're going to see the name ofthe entity.
(16:39):
And if you see that there, thenobviously.
Um, that's when you're going tobe alerted to that.
They may not have provided you aK one.
Then obviously you're going toask him for a K one at that
point, and then you're going toconfirm their percentage of
ownership.
And then you're going to askthem for the, uh, tax returns,
the 1120 S of the business sothat you can properly do your
(17:01):
income calculations where thenyou're going to put on the
schedule, a self employed barincome calculator.
It's going to have the firstline is going to be for W 2
income.
That's W 2 income from selfemployment, not W 2 income from
a, uh, a real job they may haveoutside of the W 2 income from
their self employment that somepeople do have multiple income
(17:23):
streams like that.
That would be W2 income fromtheir self employment.
And if you guys schedule BCRD orany kind of additional income
like that, that's from selfemployment would be on there.
Not the one that shows on theirregular 1040 from their regular,
uh, business activities of likedividends and interests and all
that, that is not for that, forthe self employment power or
(17:47):
income calculations.
So then you'll have the sectionthere for the, uh, 1120s
section.
And.
You'll have the section for theK 1, right, uh, on the 1120S
section, that's where you'regoing to capture the expenses,
uh, that you're going to writeoff, but that's on the next page
(18:07):
here, so then, just so you know,then from Schedule E, page 2, or
depending what page, the lastpage 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.
(18:28):
Notice all these additionalschedules and when the borrower
only sends you page 1 and 2 ofthe tax return, you know,
they're doing you a disservicehere.
Uh, so that income then, selfemployment income, goes to
Schedule 1 and then, you know,combined.
Income, losses, whatever, allcombined into one number in
Schedule 1.
And then that number fromSchedule 1 is transferred to,
(18:52):
uh, page 1, line 8 of the 1040.
So it's, it's really importantthat you follow this paper trail
so you'll know what documentsyou are missing.
In order to properly calculatethe income of your borrower and
also to note that if you see a1040 with a schedule e page 2
and there's a corporate entityon there, now you got to start
(19:12):
asking for additionaldocumentation because there's a
good possibility that yourborrower owns at least 25
percent of something or more andis actually self employed.
So I was touching base on the1120s income and expenses,
right?
And, uh, basically I want toshare right here our key
(19:36):
concepts for that because that'sanother component when you're
completing the, um, income andexpense worksheet that you need
to know what numbers to put inthere and what numbers not to
put in there.
Because the worksheet just tellsyou, grab the number from line
number 31, grab the number fromline number 21, from line number
(19:59):
1 of the K1, but it doesn't, youknow, you got to know why you're
grabbing it, and if you're ableto actually use that number, and
it boils down to.
To a couple of, of, uh,categories here.
The first one is non cashexpenses.
These are expenses that can beadded back to the income.
(20:20):
So when you're doing the 1120ssection of the self employed
borrower income calculator,these categories are the ones
that typically can be addedback, uh, really easily.
So the first category isdepreciation.
It could be either real estate.
Uh, or, uh, or chat or a chattelasset like furniture or
(20:43):
equipment, mind you, it could beon 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 anydepreciation on the first page,
look through the whole taxreturn and see, you may see it
in a, in a, in another schedule.
(21:05):
Um, that's a great one to addback now.
Depletion.
Rarely do we find it, butdepletion is when a business,
uh, uses a natural resource likeoil.
So depletion is the exhaustionof a natural resource that they
need for their businessoperation.
And, uh, the logic here is toallow them to recoup, uh, uh,
(21:29):
have less, you know, havecredits towards their income so
that they can save money.
to be able to purchase thesenatural resources again to
continue their businessoperation.
And then a really tricky one isamortization.
Now, amortization is not whatyou typically consider, right?
Uh, amortization when, uh, MLOnormally hears it, they're
(21:50):
thinking, um, the amortizationof a loan, right?
The principal balance, thepaying down of the balance of a
loan, right?
The amortization.
But that's not what we'retalking about here.
Amortization.
would be one time businessstartup expenses like patents,
uh, surveys, uh, building upgoodwill, a lot of things like
(22:14):
that before the business even,uh, begins operating that you
need to invest in.
And typically the word thatneeds to appear in the expense
category is Amortization.
Now, you may be able to get awaywith it and it specifically says
one time business startupexpenses or something like that
(22:36):
or business startup expenses andit lists them out.
Then you can tell the, uh, theunderwriter, hey, listen, um,
what they really meant here wasamortization.
So then you can recapture thatexpense.
and added back to the um,business, uh, to the income,
right?
Because it's one time businessstartup expenses that is never
going to occur again with thatbusiness once the business is up
(22:58):
and running.
That's why it's considered a noncash expense.
Second category here is expenseslimited by the IRS.
Now these, this category, anyexpenses in this category are
reduced from the income, right?
It's a subtraction, not anaddition.
(23:19):
The logic here is that typicallythese expenses that are limited
by the IRS, that means that theIRS does not allow you to recoup
or to charge off 100 percent ofthat expense.
So the logic is that thepercentage that you are not
allowed to write off.
(23:40):
Is the amount that has to bededucted from the income.
So, uh, the most popularcategory for this is meals,
meals and entertainment.
I believe it's how they call itin this, in the, uh, the tax
form.
IRS only allows you to deduct50%.
of this amount.
(24:01):
So the other 50 percent isreduced from the income.
That's, that's how that oneworks.
And I've seen these pretty highamounts, seven, eight, nine, 10,
11, 12, 000 in some tax returns,depending on the type of
business that they're in, wherethey may be thinking a lot of
people out to, you know, lunchand dinners and stuff like that.
(24:21):
And, uh, the last category herein these very important key
concepts, this is a superimportant one, saved more than
one deal for me, is therelationship between recurring
and non recurring income.
Or loss, right?
So first, what do we mean byrecurring?
(24:42):
Recurring means that that item,whether it's an expense stream
or income stream, is expected tocontinue 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 onetime event that cannot be
(25:04):
considered towards income orexpenses.
So, what are some real worldexamples here of, of these and
really it's more of the nonrecurring ones are the ones that
we really need to considerbecause we're going to have non
recurring income, but especiallywe're going to have non
(25:25):
recurring losses.
That's really the one that isgoing to allow us to save the
deal because that loss isreduced from, from gross revenue
and it affects your bottom line.
So if you can get that lossadded back, you could in some
cases significantly increaseyour bottom line.
(25:46):
Your net income.
So, uh, the non recurring, uh,type examples would be sale of
an asset where the business isnot in that type of business,
right?
So let's say you have a businessthat sells, uh, two of their
trucks, right?
Some nice, uh, fancy type ofvehicles and they, they get 140,
(26:12):
000.
For this, this specializedequipment because they're buying
the latest generation one, butthey're actually in, let's say
agriculture.
They're not in the, in thebusiness of selling heavy
equipment.
So that 140, 000 of income wouldnot be able to be used towards
(26:34):
income.
So that one hopefully is, uh,uh, pretty obvious.
Now, the one that could be alittle trickier is when you're
trying to get that loss.
Uh, removed and get it addedback.
Now, a real, uh, common, two ofthe most common, um, areas of
this would be a casualty loss,right?
(26:55):
Like, uh, theft.
Fire, hurricane, uh, you know,uh, which caused a loss of
business and they had to put ina 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, 000on the policy before it kicked
in.
So they wrote off that 50, 000as a loss.
(27:17):
Right, but that's a casualtyloss.
So that can be added back aslong as they provide
documentation from the claim andwhat they paid out and what they
didn't pay out and all that kindof very easily obtainable
documentation and the other verycommon, uh, non recurring loss
would be a paper loss.
(27:39):
that has been carried forward.
So a carry forward loss wheremaybe three years ago they had a
big loss in some kind ofcategory that then they are
allowed to carry that lossforward for the next maybe five
years or the next 10 years,whatever it may be.
Uh, then that one would requiredocumentation from the
(28:02):
accountant to clearly explainThe accounting rule that was
used and the type of, you know,what actually was the original
loss and that it's a carryforward paper loss, and then you
should be able to get that loss,uh, added back to the income,
right?
In some cases, these carryforward paper losses can be a
(28:24):
very significant amount.
So.
Really important here, these keyconcepts.
This is where I also see, uh, ifyou got all your documentation
and you've overcome that hurdlewhere you have your 1120s and
your 1040, then, you know, theother obstacle is actually, you
know, knowing what you'rereading.
(28:45):
And last but not least, do knowthat you are, depending on, uh,
what time of the year the loanis occurring.
If the loan is occurring in thefirst quarter of the year and
the tax returns presented arevery recent, right?
Like it's March 10th and the taxreturns are, um, are from 20,
(29:06):
you know, 24 and it's March 10of 2025, then you're good with
just the tax returns.
However, once you exceed thefirst quarter of the year and
the tax returns are from prior,now they were, you know, then
you're, you're going to have toprovide a P& L.
Even if you get the tax returnsnow.
(29:26):
on let's say June 10th, datedJune 10th.
It's not the day they date thetax return because that tax
return is for the businessactivity of 2024, right?
So you would still have toprovide, or the borrower would
have to provide a signed profitand loss statement.
For the business, the year todate business activity from
January 1st through June 10th orlet's say May 31st.
(29:50):
We were doing a June 10th loanto document the income of the
company to make sure that it iscontinuing the same.
Please note that they're notgoing to let you add income from
a real juicy looking profit andloss, but they will certainly
(30:10):
deduct.
Income, if the profit and lossshows a lower income than
whatever you were showing as themonthly income, depending on if
you had a one year or two yearfindings, whatever you were
doing, and your income wascalculated, 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, permonth, now you got a big
(30:34):
problem.
Now you have seriously decliningincome, and we're going to have
to get explanations from, fromthe borrower, from the
accountant, as to is this justtiming, you know, most of the
contracts come in later in theyear, are we in the slow season,
what's going on that the P& L isshowing, uh, such a reduced,
(30:55):
keep in mind how P& Ls are to beused.
So, uh, I'm going to give it amoment to see if we have any
questions.
Uh, this is a very, veryimportant, uh, training today on
S Corps.
Uh, we have the main pointshere, uh, of guidance to
properly analyzing that income,knowing what documentation to
(31:17):
ask for, uh, so that you can,not have any obstacles.
Okay, so, uh, hopefully it wasvery 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 seeingyou, uh, next Tuesday.
(31:39):
And remember, next week we aregoing to be analyzing the very
tricky C Everybody have a greatday.
Oh, wait, we got a quick, uh,last minute question here.
Any way to work around addingback health insurance tax credit
if required to pay it back?
(31:59):
Wow, that's a, that's a trickyone.
Any way to work around addingback insurance tax credit?
I'm not sure if I understand thequestion.
I think they're the question isif you're if you're required to
pay it back and you add it back.
I'm not really sure if Iunderstand the question.
(32:22):
That's not one of the normalcategories of expenses that we
are able to add back to income.
Seems like that's one where wewould be looking for an
exception.
Uh, because, uh, they'rerequired to pay it back.
Anyhow, so we're looking to seeif we can edit that.
I'm not really sure, but I'venever encountered that one.
(32:45):
Uh, I'd be, uh, interested ingetting some, uh, more
information on it from the MLOthat posed the question.
So, do look forward to seeingyou all next week, and have a
great, uh, holiday weekend.
So let's get right into it.
So an S corporation is a legalentity with a limited number of
stockholders.
Now, real important to note herein these key points is
stockholders are not personallyliable for the debts incurred by
(00:21):
the corporation.
Um, a corporation has articlesof incorporation that are filed
with the secretary of state forthe 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 anS corporation borrower are the,
(00:45):
the EIN letter that theyreceived from the IRS and
operating agreement, uh, whichwill document their percentage
of ownership, uh, if you're notgoing full doc, I mean, if
you're going full doc, it'sgoing to be on the K one, right?
Uh, and then you have the EINletter Or see that's how we
(01:05):
already covered it and theoperating agreement.
Yeah.
Yeah.
And uh, the corporate resolutionactually, it's uh, what I meant
to say, which at the end is adocument that gives them the
authorization to transactbusiness for the corporation.
If, for example, they're takingtitle in a corporate entity, for
example.
So, ANS Corp is a pass throughentity, real important point
(01:32):
here, where the profit and lossis passed to the individual
stockholders according to theirpercentage of ownership.
So I was mentioning the ScheduleK 1, uh, that is the document
that is used to, um, pass eitherthe, uh, income or loss.
(01:55):
to the stockholder according totheir proportionate share.
So if they're 100 percent ownerof the S corp, of the stocks in
the S corp, then it's going toshow 100 percent on the K 1.
If they're 33 percent owner,it's going to show 33%.
Keep in mind, uh, that in orderto be considered self employed,
(02:19):
Uh, the individual has to haveat least a 25 percent or greater
ownership interest in the SCorp.
Less than 25%, they're notconsidered self employed.
So that's a key componentbecause sometimes, uh, as part
of quality control, when they'redoing the background search, the
(02:39):
individual, also known as fraudguard, Um, the S Corp or LLC may
come up, uh, linked to theborrower and then you have to
provide documentation to showthat they're not an owner, that
they're not considered selfemployed.
Would be normally, if it's afull doc deal, you're, you're
going to provide a K 1.
(02:59):
Um, if it's not a full doc deal,you'll probably provide an
operating agreement.
or something to the effect aletter from the tax preparer as
well.
Um, so that means that thecorporation doesn't pay any of
the taxes.
The taxes on the income are paidfor by the borrower, by the
(03:22):
stockholder via the 1040.
Please also note now that aborrower may receive W 2 wages
from his or her S corp.
as a supposed quote unquoteemployee, right?
But they're not really anemployee of their own
(03:44):
corporation.
They just are receiving W 2income and that because that's
the way that they are drawingpart of the money from the
company, right?
They're drawing part of theirearnings from the company via W
2 so they can have some payrolltaxes and all that kind of good
stuff that's associated withthat.
We're talking about Medicaretax, income tax, stuff that I
(04:08):
guess would go towards yourretirement, and also their tax
strategy, depending on whattheir accountant has advised.
Some may just take it all asretained earnings, and then you
see it in their 1099 Schedule C,possibly, or, or just straight
up into 1040.
But, The important thing to notehere is that, um, you know, if
(04:32):
they do receive W 2 wages fromtheir S corporation, of which
they are at least 25%, or moreowner of the stock of the S
Corp, then they are consideredself employed.
They are not an employee andyou, you have to follow whatever
documentation requirements youneed for a self employed
(04:55):
borrower and not for a W 2employee.
This has been, uh, has createdconfusion in the because, you
know, we have a borrower turnsin pay stubs.
Uh, turns in a W 2, uh, the,it's a full doc deal, agency
loan gets run through automatedunderwriting.
(05:17):
Let's say we're doingconventional.
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 comesback or somebody reviews the W
(05:40):
2s or does a check on thecompany, whatever may happen,
that all of a sudden we findout, hey, wait a minute, he's an
owner of the company.
So now the deal has to getrestructured.
Uh, we run it through automatedunderwriting.
Now, all of a sudden we don'tget the one year findings.
We have the two year findings.
Uh, the business has only beenin business for three years, so
(06:00):
we can't go LP for theautomatic.
If you've been in business fiveyears or greater, only use one
year.
DU gives it to you if they likethe 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'retalking Fannie Mae, LP, Freddie
Mac.
So in that scenario, now all ofa sudden our loan totally
(06:22):
changes because now we have toprovide two years tax returns
and wouldn't you know it, the22, the 2022 tax return, uh, was
abysmal, right?
Uh, didn't do that well and nowwe have to average that really
low 2022 with a 2023 and now ourincome is shot.
(06:45):
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 seethat it's not like a big company
or anything like that.
So, uh, for the self employedborrower, right, though, that
(07:07):
borrower that we've determinedthat's 25 percent or greater
ownership interest in the Scorp, uh, the standard is for a
two year history of selfemployment requirement in order
to be able to consider the selfemployment income.
Right.
That's like the, the standardthreshold.
However, like with a lot ofthings in this business, there
(07:31):
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, fullself employment.
Uh, one of the exceptions wouldbe if the borrower is receiving
same or greater income In asimilar field.
(07:54):
or position.
And the second would be, theseare very similar, but it's just
a little difference in thewording where one talks about
income doing a similar field orposition and the other one talks
about borrower in a similaroccupation in which they had
similar responsibilities.
So what would be some real, uh,world examples for this, right?
(08:19):
And by the way, this is going tobe applicable.
For full doc type loans going toagency or for example, bank
statement loans, right?
It's the same concept.
You just have to reviewguidelines, right?
This is a generalization of whatthe guidelines state in agency
loans.
And then obviously non QM, allthe guidelines are going to be
(08:41):
different.
Some allow for this exception,some don't.
So real life examples here wouldbe You have a nurse, right?
A nurse has a, typically has anursing license, some type of
certification.
This nurse is working as anemployee for a doctor.
(09:01):
Now the nurse decides to go1099, right?
She formed, uh, maybe she formedan 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 nursinglicense for the nurse.
It's, uh, and anybody else thathas a license, it's going to be
(09:23):
a lot easier because you'relinking the experience to the
license.
Very easily verifiablecomponent, right?
Electrician's license, nursinglicense, doctors, right?
Attorney, right?
Was working for a firm.
Now they have their own firm.
So the key component there isgoing to be either reading the
(09:46):
findings.
If it's an agency loan, uh, fromyour automated underwriting
submission or reading theguidelines and seeing what they
allow typically in the findingsthat 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 ofincome for that income stream in
(10:11):
the last tax return, right?
So in other words, if 2023, forexample, they were doing it from
January 1st.
Until December 31st, becausethey actually started doing that
type of job in December 15th,going self employment.
Then you would have one year's12 months actually is what they
(10:33):
require worth of income on thattax return You're probably going
to be good.
They're going to average it outMaybe with the w 2 income that
they had or not, depending whichis the, the, the bullet point
that you're using to, uh, try toget the exception.
If you're going with the similaror same or greater income in a
(10:53):
similar field of position,you're probably going to average
it out.
If not, you're looking at thelicensing, uh, and obviously
you're going to push theaveraging out if there was good
income right from the W 2.
If not, you're going to go withthe, hey, let's just use their
self employment income now andthen let's hope that it's a
really good.
So, you're, you're seeing howyou can get the exception to
(11:15):
less than two years in business,uh, and it's really going to be
linked to what were they doingpreviously.
There were a similar type ofinvolvement, then there's a very
good chance that you're going toget, uh, the exception.
Now, for, um, in terms of theincome stream.
(11:36):
Right now, this is a veryimportant that you follow the
paper trail here because this iswhere, uh, many MLOs make the
mistake when they'recalculating, they're analyzing
and calculating what they need.
We get the borrower selfemployed.
All they're giving us is a 1040.
Uh, they don't know they got tonecessarily give us the 1120s
(12:00):
and maybe the MLO didn't ask forthe 1120s.
If they're, if they have anescort.
But or maybe they are saying nowhere's this is how you can also
see that the W2 borrower whosays that he's an employee is
really.
And owner, right?
(12:20):
This is where you're going to,this is where your detective
work comes into play when you'reanalyzing the documentation,
because first and foremost, thebusiness income, in other words,
the profit and loss breakdown ofthat business, of that S corp is
going to be reported on IRS form1120 S as in Sam, that's an S
(12:41):
corp tax return.
Every S corp needs a file.
By the way, sometimes you'regoing to see people that have an
LLC file and you live in 20 s.
They have the LLC for liabilityreasons and then they're filing.
As a single uh, member, LLC, inan SCORP to be able to file
(13:01):
their documentation because the10 65, and this is for another
lesson, but the 10 65 is forpartnerships.
So if you have an LLC, singlemember LLC and you gonna file a
tax return, you're probablygonna have to set up a SCORP and
file an 1120 s as well.
So, uh, now note the 1120 sbreakdown of all the expenses on
(13:24):
page one.
Right.
Page one has the, the, uh, thegross sales or revenue, has all
of the expense components.
The main expense components arelisted there and then you get
reference to other statements orpages on that.
Um, so that's where you're goingto see all of the breakdowns.
So, when you're doing your selfemployment borrower income
(13:45):
calculations of an S corpborrower, you need to have the S
corp.
tax return because that's whereyou're going to draw items such
as depreciation, amortization,depletion, and all those other
items like that, that you, plusthe income.
The main income of the corporateside because on the worksheet,
(14:07):
you're going to have thatsection plus you're going to
have the K one section whereyou're going to document then
where each partners share theireach partners proportionate
share of their income.
So if you have threestockholders in that escort,
there are thirty three pointthree, three, three, three
percent.
Owner each one.
(14:28):
So each partner's share is goingto be reported on the K one,
right?
And that's going to say 33.
33 percent owner is going tolist the income, the ordinary
income on line one, then, uh,you're going to have
distributions, usually on line16, D as in dog, that's very
important because in acorporation, the only income
(14:50):
that you are really going tocount.
Is the income that isdistributed on 16 D unless the
business has liquidity, right?
Uh, assets greater thanliabilities.
Then you can use the statedincome on line one, even though
they may not have distributedany of that income on box 16 D.
(15:14):
That's what the distributionsare when they actually
physically take the money out ofthe business and into their
possession on a personal basis.
basis, right?
So, um, so you'll know that itgoes from the 1120s.
The income is then reported tothe each partner on the K 1 and
(15:36):
then that amount reported on theK 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, pagetwo.
Now, most people know theSchedule E as the schedule for,
(15:57):
uh, real estate, right?
Where you have real estate, uh,income and expenses for each of
your properties.
I think it's like threeproperties you can put per page
on a Schedule E.
So you need more than one pageif you have more than three
properties.
And then the final page, Thelast page of the schedule E in
this case, if you have more thanone schedule, it wouldn't be
page two.
It'd be the final page of theschedule.
(16:18):
It would be the page that showsany 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 passiveincome, non passive income,
passive loss, non passive loss.
You're going to see a tax IDnumber.
You're going to see the name ofthe entity.
(16:39):
And if you see that there, thenobviously.
Um, that's when you're going tobe alerted to that.
They may not have provided you aK one.
Then obviously you're going toask him for a K one at that
point, and then you're going toconfirm their percentage of
ownership.
And then you're going to askthem for the, uh, tax returns,
the 1120 S of the business sothat you can properly do your
(17:01):
income calculations where thenyou're going to put on the
schedule, a self employed barincome calculator.
It's going to have the firstline is going to be for W 2
income.
That's W 2 income from selfemployment, not W 2 income from
a, uh, a real job they may haveoutside of the W 2 income from
their self employment that somepeople do have multiple income
(17:23):
streams like that.
That would be W2 income fromtheir self employment.
And if you guys schedule BCRD orany kind of additional income
like that, that's from selfemployment would be on there.
Not the one that shows on theirregular 1040 from their regular,
uh, business activities of likedividends and interests and all
that, that is not for that, forthe self employment power or
(17:47):
income calculations.
So then you'll have the sectionthere for the, uh, 1120s
section.
And.
You'll have the section for theK 1, right, uh, on the 1120S
section, that's where you'regoing to capture the expenses,
uh, that you're going to writeoff, but that's on the next page
(18:07):
here, so then, just so you know,then from Schedule E, page 2, or
depending what page, the lastpage 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.
(18:28):
Notice all these additionalschedules and when the borrower
only sends you page 1 and 2 ofthe tax return, you know,
they're doing you a disservicehere.
Uh, so that income then, selfemployment income, goes to
Schedule 1 and then, you know,combined.
Income, losses, whatever, allcombined into one number in
Schedule 1.
And then that number fromSchedule 1 is transferred to,
(18:52):
uh, page 1, line 8 of the 1040.
So it's, it's really importantthat you follow this paper trail
so you'll know what documentsyou are missing.
In order to properly calculatethe income of your borrower and
also to note that if you see a1040 with a schedule e page 2
and there's a corporate entityon there, now you got to start
(19:12):
asking for additionaldocumentation because there's a
good possibility that yourborrower owns at least 25
percent of something or more andis actually self employed.
So I was touching base on the1120s income and expenses,
right?
And, uh, basically I want toshare right here our key
(19:36):
concepts for that because that'sanother component when you're
completing the, um, income andexpense worksheet that you need
to know what numbers to put inthere and what numbers not to
put in there.
Because the worksheet just tellsyou, grab the number from line
number 31, grab the number fromline number 21, from line number
(19:59):
1 of the K1, but it doesn't, youknow, you got to know why you're
grabbing it, and if you're ableto actually use that number, and
it boils down to.
To a couple of, of, uh,categories here.
The first one is non cashexpenses.
These are expenses that can beadded back to the income.
(20:20):
So when you're doing the 1120ssection of the self employed
borrower income calculator,these categories are the ones
that typically can be addedback, uh, really easily.
So the first category isdepreciation.
It could be either real estate.
Uh, or, uh, or chat or a chattelasset like furniture or
(20:43):
equipment, mind you, it could beon 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 anydepreciation on the first page,
look through the whole taxreturn and see, you may see it
in a, in a, in another schedule.
(21:05):
Um, that's a great one to addback now.
Depletion.
Rarely do we find it, butdepletion is when a business,
uh, uses a natural resource likeoil.
So depletion is the exhaustionof a natural resource that they
need for their businessoperation.
And, uh, the logic here is toallow them to recoup, uh, uh,
(21:29):
have less, you know, havecredits towards their income so
that they can save money.
to be able to purchase thesenatural resources again to
continue their businessoperation.
And then a really tricky one isamortization.
Now, amortization is not whatyou typically consider, right?
Uh, amortization when, uh, MLOnormally hears it, they're
(21:50):
thinking, um, the amortizationof a loan, right?
The principal balance, thepaying down of the balance of a
loan, right?
The amortization.
But that's not what we'retalking about here.
Amortization.
would be one time businessstartup expenses like patents,
uh, surveys, uh, building upgoodwill, a lot of things like
(22:14):
that before the business even,uh, begins operating that you
need to invest in.
And typically the word thatneeds to appear in the expense
category is Amortization.
Now, you may be able to get awaywith it and it specifically says
one time business startupexpenses or something like that
(22:36):
or business startup expenses andit lists them out.
Then you can tell the, uh, theunderwriter, hey, listen, um,
what they really meant here wasamortization.
So then you can recapture thatexpense.
and added back to the um,business, uh, to the income,
right?
Because it's one time businessstartup expenses that is never
going to occur again with thatbusiness once the business is up
(22:58):
and running.
That's why it's considered a noncash expense.
Second category here is expenseslimited by the IRS.
Now these, this category, anyexpenses in this category are
reduced from the income, right?
It's a subtraction, not anaddition.
(23:19):
The logic here is that typicallythese expenses that are limited
by the IRS, that means that theIRS does not allow you to recoup
or to charge off 100 percent ofthat expense.
So the logic is that thepercentage that you are not
allowed to write off.
(23:40):
Is the amount that has to bededucted from the income.
So, uh, the most popularcategory for this is meals,
meals and entertainment.
I believe it's how they call itin this, in the, uh, the tax
form.
IRS only allows you to deduct50%.
of this amount.
(24:01):
So the other 50 percent isreduced from the income.
That's, that's how that oneworks.
And I've seen these pretty highamounts, seven, eight, nine, 10,
11, 12, 000 in some tax returns,depending on the type of
business that they're in, wherethey may be thinking a lot of
people out to, you know, lunchand dinners and stuff like that.
(24:21):
And, uh, the last category herein these very important key
concepts, this is a superimportant one, saved more than
one deal for me, is therelationship between recurring
and non recurring income.
Or loss, right?
So first, what do we mean byrecurring?
(24:42):
Recurring means that that item,whether it's an expense stream
or income stream, is expected tocontinue 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 onetime event that cannot be
(25:04):
considered towards income orexpenses.
So, what are some real worldexamples here of, of these and
really it's more of the nonrecurring ones are the ones that
we really need to considerbecause we're going to have non
recurring income, but especiallywe're going to have non
(25:25):
recurring losses.
That's really the one that isgoing to allow us to save the
deal because that loss isreduced from, from gross revenue
and it affects your bottom line.
So if you can get that lossadded back, you could in some
cases significantly increaseyour bottom line.
(25:46):
Your net income.
So, uh, the non recurring, uh,type examples would be sale of
an asset where the business isnot in that type of business,
right?
So let's say you have a businessthat sells, uh, two of their
trucks, right?
Some nice, uh, fancy type ofvehicles and they, they get 140,
(26:12):
000.
For this, this specializedequipment because they're buying
the latest generation one, butthey're actually in, let's say
agriculture.
They're not in the, in thebusiness of selling heavy
equipment.
So that 140, 000 of income wouldnot be able to be used towards
(26:34):
income.
So that one hopefully is, uh,uh, pretty obvious.
Now, the one that could be alittle trickier is when you're
trying to get that loss.
Uh, removed and get it addedback.
Now, a real, uh, common, two ofthe most common, um, areas of
this would be a casualty loss,right?
(26:55):
Like, uh, theft.
Fire, hurricane, uh, you know,uh, which caused a loss of
business and they had to put ina 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, 000on the policy before it kicked
in.
So they wrote off that 50, 000as a loss.
(27:17):
Right, but that's a casualtyloss.
So that can be added back aslong as they provide
documentation from the claim andwhat they paid out and what they
didn't pay out and all that kindof very easily obtainable
documentation and the other verycommon, uh, non recurring loss
would be a paper loss.
(27:39):
that has been carried forward.
So a carry forward loss wheremaybe three years ago they had a
big loss in some kind ofcategory that then they are
allowed to carry that lossforward for the next maybe five
years or the next 10 years,whatever it may be.
Uh, then that one would requiredocumentation from the
(28:02):
accountant to clearly explainThe accounting rule that was
used and the type of, you know,what actually was the original
loss and that it's a carryforward paper loss, and then you
should be able to get that loss,uh, added back to the income,
right?
In some cases, these carryforward paper losses can be a
(28:24):
very significant amount.
So.
Really important here, these keyconcepts.
This is where I also see, uh, ifyou got all your documentation
and you've overcome that hurdlewhere you have your 1120s and
your 1040, then, you know, theother obstacle is actually, you
know, knowing what you'rereading.
(28:45):
And last but not least, do knowthat you are, depending on, uh,
what time of the year the loanis occurring.
If the loan is occurring in thefirst quarter of the year and
the tax returns presented arevery recent, right?
Like it's March 10th and the taxreturns are, um, are from 20,
(29:06):
you know, 24 and it's March 10of 2025, then you're good with
just the tax returns.
However, once you exceed thefirst quarter of the year and
the tax returns are from prior,now they were, you know, then
you're, you're going to have toprovide a P& L.
Even if you get the tax returnsnow.
(29:26):
on let's say June 10th, datedJune 10th.
It's not the day they date thetax return because that tax
return is for the businessactivity of 2024, right?
So you would still have toprovide, or the borrower would
have to provide a signed profitand loss statement.
For the business, the year todate business activity from
January 1st through June 10th orlet's say May 31st.
(29:50):
We were doing a June 10th loanto document the income of the
company to make sure that it iscontinuing the same.
Please note that they're notgoing to let you add income from
a real juicy looking profit andloss, but they will certainly
(30:10):
deduct.
Income, if the profit and lossshows a lower income than
whatever you were showing as themonthly income, depending on if
you had a one year or two yearfindings, whatever you were
doing, and your income wascalculated, 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, permonth, now you got a big
(30:34):
problem.
Now you have seriously decliningincome, and we're going to have
to get explanations from, fromthe borrower, from the
accountant, as to is this justtiming, you know, most of the
contracts come in later in theyear, are we in the slow season,
what's going on that the P& L isshowing, uh, such a reduced,
(30:55):
keep in mind how P& Ls are to beused.
So, uh, I'm going to give it amoment to see if we have any
questions.
Uh, this is a very, veryimportant, uh, training today on
S Corps.
Uh, we have the main pointshere, uh, of guidance to
properly analyzing that income,knowing what documentation to
(31:17):
ask for, uh, so that you can,not have any obstacles.
Okay, so, uh, hopefully it wasvery 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 seeingyou, uh, next Tuesday.
(31:39):
And remember, next week we aregoing to be analyzing the very
tricky C Everybody have a greatday.
Oh, wait, we got a quick, uh,last minute question here.
Any way to work around addingback health insurance tax credit
if required to pay it back?
(31:59):
Wow, that's a, that's a trickyone.
Any way to work around addingback insurance tax credit?
I'm not sure if I understand thequestion.
I think they're the question isif you're if you're required to
pay it back and you add it back.
I'm not really sure if Iunderstand the question.
(32:22):
That's not one of the normalcategories of expenses that we
are able to add back to income.
Seems like that's one where wewould be looking for an
exception.
Uh, because, uh, they'rerequired to pay it back.
Anyhow, so we're looking to seeif we can edit that.
I'm not really sure, but I'venever encountered that one.
(32:45):
Uh, I'd be, uh, interested ingetting some, uh, more
information on it from the MLOthat posed the question.
So, do look forward to seeingyou all next week, and have a
great, uh, holiday weekend.
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