Partnerships and some LLCs use IRS Form 1065 for filing informational federal income tax returns for the partnership or LLC. The partner’s or member-owner’s share of income (or loss) is carried over to IRS Form 1040, Schedule E. See B3-3.2-02, Business Structures, for more information on partnerships and LLCs.
A borrower with an ownership interest in a partnership or LLC may receive income in the form of wages or other compensation from the partnership or LLC in addition to the borrower’s proportionate share of income (or loss) reported on the Schedule K-1.
When the borrower has 25% or more ownership interest in the business and business tax returns are required, the lender must perform a business cash flow analysis and evaluate the overall financial position of the borrower’s business to determine whether
income is stable and consistent, and
sales and earnings trends are positive.
If the business does not meet these standards, business income cannot be used to qualify the borrower.
Items that can be added back to the business cash flow include depreciation, depletion, amortization, casualty losses, and other losses that are not consistent and recurring.
The following items should be subtracted from the business cash flow:
meals and entertainment exclusion,
other reported income that is not consistent and recurring, and
the total amount of obligations on mortgages or notes that are payable in less than one year.
These adjustments are not required for lines of credit or if there is evidence that these obligations roll over regularly and/or the business has sufficient liquid assets to cover them.
Income from partnerships, LLCs, estates, or trusts can only be considered if the lender obtains documentation, such as the Schedule K-1, verifying that
the income was actually distributed to the borrower, or
the business has adequate liquidity to support the withdrawal of earnings. If the Schedule K-1 provides this confirmation, no further documentation of business liquidity is required.
The lender may use discretion in selecting the method to confirm that the business has adequate liquidity to support the withdrawal of earnings. When business tax returns are provided, for example, the lender may calculate a ratio using a generally accepted formula that measures business liquidity by deriving the proportion of current assets available to meet current liabilities.
It is important that the lender select a business liquidity formula based on how the business operates. For example:
The Quick Ratio (also known as the Acid Test Ratio) is appropriate for businesses that rely heavily on inventory to generate income. This test excludes inventory from current assets in calculating the proportion of current assets available to meet current liabilities.
Quick Ratio = (current assets — inventory) ÷ current liabilities
The Current Ratio (also known as the Working Capital Ratio) may be more appropriate for businesses not relying on inventory to generate income.
Current Ratio = current assets ÷ current liabilities
For either ratio, a result of one or greater is generally sufficient to confirm adequate business liquidity to support the withdrawal of earnings.
The table below provides references to the Announcements that have been issued that are related to this topic.