One of the most common topics I run across for self-employed borrowers is the discussion on ”The dreaded Distribution Versus Ordinary Income”. Even though the guidelines clearly outlined these requirements for years, they never seemed to be enforced. The guidelines were largely ignored by lenders selling to both agencies. Since FNMA has brought the distribution of business income back, as an industry I think we are still a little “wobbly legged” over the requirements. To help get us back on our feet, over the last twelve to eighteen months FNMA has slightly modified the guidance to help the industry adopt and understand the distribution concept .
SEL 2016-05 Changes
On June 28th FNMA with SEL 2016-05 has tweaked and clarified the guidelines again to assist lenders with how to evaluate if the borrower had actually received the business income from a partnership (1065 tax form), S Corporation (1120S), or an LLC (1065 Tax Form) .
First FNMA has now eliminated the need to provide a partnership agreement or corporate resolution to support “access to income”. I really applaud this move because reviewing these documents really did not clear up anything, and most of the time just generated more confusion.
Second FNMA has endorsed a more numbers based approach to evaluate the ability for a company to distribute income. NOTE these ratios are only needed if the borrowers K-1’s doesn’t show distribution of income that supports your K-1’s and cash flow adjustments.
Here is some of the new guidance from AllRegs:
B3-3.2.2-01: Analyzing Partnership Returns for a Partnership or LLC (06/28/2016)
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.
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.
The Current Ratio (also known as the Working Capital Ratio) may be more appropriate for businesses not relying on inventory to generate income.
For either ratio, a result of one or greater is generally sufficient to confirm adequate business liquidity to support the withdrawal of earnings.
End quotes from FNMA AllRegs
Using the new guidance, we created the following examples of the formulas using the current 2015 tax forms to source the location of each line needed to follow the math provided by FNMA. Keep in mind the entire purpose of this test is to answer one question. “Was the business able to distribute the income?”
Hopefully that puts FNMA SEL 2016-05 in a bit more context for you. For next week’s blog lest discuss this math a little further, FNMA updating their guidelines with this information was very helpful, but let’s break down the schedule L a little further and see if we can maybe more accurately find out if a business is solvent.