The version of Schedule K-1 that is utilized to report a borrower’s share of income (or loss) is based on how the business reports earnings for tax purposes:
partnership — reported on IRS Form 1065, Schedule K-1;
S corporation — reported on IRS Form 1120S, Schedule K-1; and
LLC — reported on either IRS Form 1065 or IRS Form 1120S, Schedule K-1, depending on how the federal income tax returns are filed for the LLC.
The lender must use caution when including income that the borrower draws from the borrower’s partnership or S corporation as qualifying income. Ordinary income, net rental real estate income, and other net rental income reported on Schedule K-1 may be included in the borrower’s cash flow provided the lender can confirm that the business has adequate liquidity to support the withdrawal of earnings, as described below:
If the borrower has a two-year history of receiving “guaranteed payments to the partner” from a partnership or an LLC, these payments can be added to the borrower’s cash flow.
If the Schedule K-1 reflects a documented, stable history of receiving cash distributions of income from the business consistent with the level of business income being used to qualify, then no further documentation of access to the income or adequate business liquidity is required. But if the Schedule K-1 does not reflect a documented, stable history, then the lender must confirm adequate business liquidity, as discussed below.
If business tax returns are required, then the lender must consider the type of business structure and analyze the business returns, according to the requirements described in B3-3.2-01, Underwriting Factors and Documentation for a Self-Employed Borrower.
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 following table describes the documentation that the borrower must provide. The borrower must select one item from each row.
The table below provides references to the Announcements that have been issued that are related to this topic.