Episode Transcript
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Restream recording Dec 11, (00:00):
Self
employed borrowers are a
challenge as we all know.
I'm trying to get their loansclosed, but the challenges
aren't just regarding the incomeof the borrower.
The challenge is also in somecases, uh, documenting that the
borrower is self employed.
and documenting their percentageof ownership in the business to
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ensure that they qualify as aself employed borrower and to
ensure that we are allocatingtheir proportionate share of
income to the incomecalculations.
So those are the challenges weface and let's break it down to
see how we can assist.
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Underwriting guidelines willalways require verifying the
borrower's ownership of abusiness, right, that they are
actually self employed, and willalso require that the percentage
of ownership be clearly defined,uh, for all entities except a C
corp, right, um, where, youknow, a borrower is considered
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self employed typically if theyown at least 25 percent Of the
entity or greater unless it's aC Corp as you all know from our
previous trainings on C Corpbecause a C Corp is an actual
corporation.
It's an entity that exists untoitself.
Um, and the borrower owns sharesin the C Corp, not the C Corp,
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and you can only attributeincome or loss to that borrower
from that corporation.
If they own a hundred percent ofthe stock of the C Corp, so that
is for C corporations only.
So do understand the 25 percentrule does not necessarily apply
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to C Corp as far as businessownership.
However, there are someguidelines QM world that may
include C Corps in theirdefinition.
of 25 ownership equals selfemployed.
So for non QM, you definitelyhave to review the guidelines
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for agency.
I can pretty much guarantee thatwhat we're stating here will
hold true.
C Corp, you have to own ahundred percent of the stock.
Any other entity or businessstructure, 25 percent or more
ownership in the entity orbusiness.
qualifies you as self employed.
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So what are the challenges thatwe face, um, in these types of
situations?
Well, one challenge is thatthere are no formal ownership
documents, right?
Um, it's a sole proprietor.
He reports his income on aSchedule C.
Uh, he's not incorporated.
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He doesn't have an LLC.
He doesn't have a businesslicense, no operating agreement,
no articles of incorporation orarticles of formation.
He's just a self employedindividual.
Like for example, a handyman,right?
How many handymen do you knowthat all they do is collect the
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money when they do the job,right?
And then they put it in theirbank account.
And at the end of the year, theyfile their taxes.
They don't have a businesslicense to be a handyman.
They don't have an operatingagreement.
They don't have an LLC, no, no SCorp, so that's definitely, uh,
a challenge, right?
But there are ways to verifybusiness ownership, not just for
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this particular situation, butjust in general, to verify their
percentage of ownership andverify that they do own the
entity.
I'm going to expand on these inthe following slides, but the
ways to verify businessownership would be through a
Schedule K 1.
Is one way to do it through, um,articles of incorporation or
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articles of formation, dependingon if it's an S Corp or if it's
an LLC combined with anoperating agreement, because the
operating agreement is whatlists their percentage of
ownership and who are themembers of the business and the
amount of ownership that theyhave.
And the third way would be aletter from the tax preparer.
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Or accountant or CPA, any ofthose three.
Yeah, that's why we like to putCPA in, uh, quotes, quotation
marks, because when we'retalking about CPA and a lot of
these scenarios, we don't meanan actual licensed CPA.
That's just a word that they useto, uh, and it groups CPAs,
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accountants.
And tax preparers in the group,uh, that can provide this third
party verification for ourborrower.
Sorry about that.
So, our first one there, firstmethod is the Schedule K 1.
Now, this is, the Schedule K 1is provided to the borrower as
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part of either a 1065, Or an1120 s.
The, the 10 65 is thepartnership tax return.
Um, and the 1120 s is the Scorporation tax return and the
Schedule K one documents, uh,the distribution that the
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borrower received.
Right.
So that's one way.
Yeah.
If it's, but now this may be anissue for you to get a K one
because if it's a loan.
where tax returns are not beingprovided, then you definitely
don't want to provide a K 1,because if you provide the K 1,
they're probably going to askyou for the rest of the tax
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return to document the validityof the K 1.
And that could blow your deal,right?
Because then you're providingtax returns that document
income, which if we're doing abank statement loan, I can
guarantee you that the income onthe tax returns is not going to
equal the income on the bankstatement option, which is why
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we're doing the loan as a bankstatement loan and not a full
doc loan, right?
Too many write offs probably.
So, uh, please do know that inthe K 1, box A as in Albert in
part one will state the name ofthe entity or the business,
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right?
So that's how you're going toknow who Is issuing that K one
to the borrower, the name,that's what we're trying to
document here, right?
We're trying to document thatthe borrower owns ABC
corporation or ABC LLC.
So box a, we'll let you know theentity name that's given them
the K one.
So that's how you're going toverify the business name and
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it's given to them to ourborrower.
So that's how you're going toverify that they're getting it.
But most importantly, box G.
In part two, we'll document whatthey call the current year
allocation percentage, alsoknown as their percentage of
ownership in the business.
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So they own 35 percent in thebusiness, it's going to state
right there in box G, currentyear allocation is 35%.
And, uh, that's how we documentwith a K 1.
So like I mentioned, K 1 will beavailable if there's an S corp.
that the borrower owns.
K1 will also be available if theborrower, uh, has a partnership
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with somebody else to document,uh, their percentage of
ownership and, uh, the name ofthe entity.
So that's our first, uh, method.
Second method is with theoperating agreement.
Obviously, the operatingagreement combined with the
Articles of Incorporation or theArticles of Formation or
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Organization.
Articles of Formation orArticles of Organization
typically are what they call theArticles for an LLC.
And Articles of Incorporation istypically what they call the
Articles for an S Corp.
Um, now the Articles can verifyself employment.
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But please note, veryimportantly here, the articles
do not usually specify thepercentage of ownership in the
business.
That will only be possible toaccurately gauge through the
operating agreement, right?
Now, the operating agreementwill specify the borrower's
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percentage of ownership in thebusiness, whatever entity is
that you have.
Now, please note, A couple ofadditional points here to
consider, uh, the operatingagreement is not a publicly
filed document.
So it will need to be providedby the borrower.
You cannot go to the secretaryof state website and download an
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operating agreement for ABC LLC,for example, that's going to
have to be provided by theborrower and do please make sure
that it is signed and dated.
Um, you will most likely berequired to provide or the
borrower will be required toprovide an EIN letter from the
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IRS stating their tax ID numberfor the entity, and they will
also need to provide acertificate of status, which
then has a bunch of differentnames depending the state that
it's in.
Could be a Certificate of GoodStanding, could be a Certificate
of Existence.
Uh, the good thing is that thedocument is usually easily
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accessed in the Secretary ofState website for the state that
the, uh, entity is organized orformed.
Um, so do know, then do yoursearch.
If you do the search certificateof status for a particular state
is going to tell you in Texas,it's called the certificate of
existence, I think.
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And that document just confirmsthat the business is still
active and in good standing asfar as its filings.
in the state.
Now, please do know that if theoperating agreement is less than
two years old, right, the dateon the agreement, the signature
date, if the operating agreementis less than two years old, the
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guidelines may requireadditional verification, such as
the letter from the CPA, uh,documenting when the business
was formed.
And actually a little bit morethan that because that's our
third and final method.
for verifying businessownership.
So if you do have an operatingagreement, less than two years
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old, you're going to have toemploy two documentation
methods.
One is the operating agreement.
And then the other would be theCPA letter, unless you want to
provide just a CPA letter fromthe get go.
Uh, it is the best way to verifyself employment when the
borrower is not operating underan entity right now.
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It can be prepared, like Imentioned, by a tax preparer.
accountant or CPA, and we'llneed to provide a letter stating
the buyers or borrowerspercentage of ownership in the
business, how long the borrowerhas owned the business, and also
make sure that they mention ifthe business is still active.
Please do note that this lettershould be prepared and dated
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after the initial loanapplication date.
The reason being because thatletter refers you want to make
sure it's not expired, but thatletter can also be used as the
verbal verification ofemployment for the self employed
borrower, confirming that thebusiness is still active.
As you all know, before closingon a regular deal, not a, uh, on
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a non self employed borrowerdeal, you're usually going to
have to do a verbal verificationof employment anywhere from five
to 10 days before the note date,the note date being the closing
date.
To make sure the borrower isstill employed by the employer.
Well, this letter ofverification, the CPA letter,
can be used to verify that thebusiness is still active.
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So that letter, if the taxpreparer includes verbiage in
there that the business is stillactive, And the letter is dated,
uh, after the application date,you should be good there because
the verbal verification ofemployment for self employed
borrowers usually calls forverification within the last 120
days that the business is stillactive.
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So do pay special attention tothat condition and the number of
days that they state you got toverify before the note date.
And if your letter is, um, at orafter that date, You know, if
it's a letter 20 days ago,you're going to be good.
But if the letter is five monthsago and the condition says you
got to verify this, uh, no morethan 120 days from the note
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date, then that letter is notgoing to serve you its purpose.
And you're going to need to getan updated letter with an
updated date.
So do note the sample letterthat I have there, where it
states the firm that representsthe borrower.
And that the bar is the owner ofthe company since the date that
they own it and that they own acertain percentage of the
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company.
It states the company's mainbusiness and if it has a
website, the website address,and that the company is active,
right?
All the stuff that we need toknow.
Very important when using theCPA letter.
is we have to verify thelicense.
So you got to get their licenseor the license number.
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If they're a tax preparer,they're not going to have a
license, but they are going tohave an ID number that can be
verified on various websites toverify that they are an active
tax preparer.
The CPA is going to have alicense and the accountant may
have a license or may have theirtax preparer ID.
So you do need to do that.
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Third, um, you know thatindependent verification of the,
uh, tax preparer if you are, uh,providing a letter from the
borrower.
So, are there any questions?
This is very important here.
We are getting quite a fewself-employed borrowers.
You are gonna be asked for thiskind of, um, information.
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So do keep this handy.
So lemme give it a minute.
See if we have any questionshere on verifying self
employment for borrowers.
I must be doing a great jobbecause we don't have any
questions.
Hopefully I did a great jobexplaining this scenario and
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hopefully you guys find thisuseful when searching for
verification of your selfemployed borrowers.
Okay, so we have no questions.
So I do look forward to seeingyou all tomorrow.
Tomorrow's training.
Thank you.