S corporations and some LLCs pass gains and losses on to their shareholders, who are then taxed at the tax rates for individuals. S corporations and some LLCs use IRS Form 1120S, Schedule K-1, for filing federal income tax returns for the corporation. The shareholder’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 S corporations. A borrower with an ownership interest in an S corporation or LLC may receive income in the form of wages or dividends in addition to his or her proportionate share of business income (or loss) reported on Schedule K-1.
When the borrower has 25% or more ownership interest in the business, the lender must perform a business cash flow analysis in order to evaluate the overall financial position of the business and confirm
the business income is stable and consistent, and
the 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.
The table below provides references to the Announcements that have been issued that are related to this topic.