I have written few blogs over the last 2 years on the change in thought from FNMA / FHLMC requiring the mortgage industry to consider distributions to support the K-1 income on lines 1,2, and 3. Today the goal is not to go over guidelines but instead to sum up where the new “normal” is for the K-1 and distribution question, and how best to communicate the new math to your investors. In our latest release of UberWriter we have updated our calculators to match this new industry standard for the 1065 and 1120s to make it faster and easier to determine these two types of income.
K-1 Income Analysis Options
Here are the four most common options to determine your borrower’s income on 1065 and 1120S. Keep in mind it is best to stick with option 1 whenever you can. Using the W-2 or guaranteed payments to partners is NOT affected by the distributions question. The options below are focused only on the question of lines 1,2,3 and cash flow adjustments.
Total up lines 1,2,3 on the K-1 and the business cash flow adjustments. Compare this number to the distributions listed on the K-1. If the total is supported by the distributions or in other words the distributions are the same or higher than your total K-1 lines 1,2,3 and cash flow adjustments, no further documentation about the ability to receive the income by the borrower is needed. You can use the K-1 lines 1,2,3, and cash flow adjustments.
Total up lines 1,2,3 on the K-1 and the business cash flow adjustments. Compare this number to the distributions listed on the K-1. If the total K-1 lines 1,2,3 and cash flow adjustments are higher than the amount of the distributions shown on the K-1, the best practice is to use the lower number between your K-1 total and your distribution total to qualify. This does not mean that distributions are used in place of K-1 income it just means that you can only support the K-1 total up to the amount matching the distribution.
(Option 1 and 2 are now commonly referred to as the “lower of two” method of calculation)
If your borrower can not qualify using option two and you need the full total of K-1 income you do have another accepted method that is outlined in FNMA. However FHLMC still remains a bit vague here, but so far seems accepting of this option.
Review the business schedule L and complete a solvency test, if the business shows to be solvent you can use the full K-1 lines 1,2,3, and cash flow adjustment income. This method is basically answering the question “could the business paid out the distributions, but choose not too, or was the capital too short to pay out the distributions.”.
If the business is not solvent that may mean the borrower is not showing enough distributions because the business could not pay out the full earned income which means we can not use the K-1 income lines 1,2,3 and cash flow adjustments. If the business is solvent that may mean the business had the funds to pay out the income but may have choose not to for some business reason, or the tax prepared did not record the distributions on the K-1 which does happen.
This is where things get in the grey area. I have discussed these methods with different lenders using some of these alternative options to prove the borrower is currently receiving or has received distributions. Some of the options I have seen used include checking the balance on the Sch L M-2 to see if there was enough funds each year to pay out the income. Another option is to review the Schedule K itself to see if the business showed payout of distributions as a company to all partners. Yet another option, getting a letter from the CPA to confirm the amount of distributions received and why they were not documented on the K-1. These methods are something your risk manager must determine based on what fits best for your company risk appetite.
Communicating the income
The next step is properly displaying your income analysis. With the latest update of UberWriter it will display the 4 options described in the table seen below. Options 1, 3, and 4 is on the column to the left and option 2 is on the column to the right. By showing our clients the math side by side we feel this helps them make the best choice for their situation.
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