Analyzing Business Tax Returns
• Partnership
• Corporation
• S-Corporation
• LLC
1
Partnership
Definition: A partnership is formed when two or more
individuals form a business and share in the profits, losses and responsibilities for running the company. Each partner pays taxes on their proportionate share of the partnership’s net income.
Requirements:
• Two years 1065 with Schedule “K-1”
• Two years 1040
Income is reported on Schedule “E’ of the 1040
2
Corporation
Definition: Corporations are state-chartered business owned by the stockholders. Compensation to its officers, generally a proportion to the percentage of ownership, is shown on the corporate tax returns.
Requirements:
• Two years 1120
• Two years 1040, including W-2
Once the adjusted business income is determined, you may or may not be able to use this as income. Use corporate income cautiously.
This is income that supports the corporation.
SNMC will not allow you to use this income unless the borrower has 100% ownership.
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Definition: An ‘S’ corporation is generally a small business, with gains and losses passed on to stockholders in proportion to each stockholder’s percentage of ownership. Income is calculated from the Ordinary income/loss and the borrower receives a percentage according to ownership.
Requirements:
• Two years 1120S, along with Schedule “K-1”
• Two years 1040
Income is reported on Schedule “E” of the 1040
‘S’ Corporation
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Definition: This is a state chartered company. It can be composed of one individual or multi-membership. All income/loss is passed through the business to the LLC owners (known as members). The Federal Government does not recognize an LLC as classifications for federal tax purposes. An LLC business entity must file as a
corporation, partnership, or sole proprietorship.
Limited Liability Company or LLC
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A number of questions to keep in mind when analyzing the borrower who is self-employed:
• What is the financial stability of the business?
• What is the ability of the business to continue to generate income?
• Is the product or service in demand?
• Is the business located in the subject property or at another location?
• If this is a purchase, will this effect the borrower’s business?
• Is this a new business, or an established business?
• What is the experience and education level to operate this business?
• If the company is owned by a husband & wife, or numerous members, remember to only use the borrower’s portion.
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Date business started
Breaks out accounting method, # of K-1s and if any changes in company status
Line #10 – Guaranteed payments to
partners
If using the 1065 for additional income, depreciation and
Depletion can be added back to cash flow.
Income, Deductions and Profit
Review other deductions.
Amortization cannot be added back
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Schedule “L”
Line 16 addresses mortgage and loans that are due within the next year.
• It is very important to
determine if the business will have any debts due in less than one year. As the ending balance must be deducted from qualifying income.
Deduct meals and entertainment exclusion as only 50% is allowed per IRS Regulation.
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Line 19 addresses mortgage and loan s that have greater than one year to be paid
Income is derived from:
Line 1 + Line 10 (Borrowers Portion) + 16a and 16b + Line 17, if applicable
MINUS
Line 16-Schedule “L” and 4b of Schedule M1
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This K-1 is associated with the 1065
Verify the information matches Schedule “E” of the 1040
Section 179
Do not add back.
1065
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Income, Deductions and Profit
The corporation may operate on a fiscal year which is different from a calendar year.
This section will give you the date incorporated.
It will list if this is the initial or final return; if there is a change in address or name.
Depreciation and depletion can be added back to the corporate cash flow.
Line 31 is the total tax which needs to be deducted from line 30 to determine the corporate cash flow.
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Schedule “E” will define the borrower’s position and percentage owned.
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Line 17 addresses debts due within 1 year and it must be subtracted from the income.
Do not forget to review Line 19, loans from shareholders, and line 7, loans to shareholders
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Line 20 addresses mortgages and real estate loans due in more than 1 year.
Income is derived from:
Line 30 minus any tax due plus Line 20 & 21, if applicable
minus Line 17 on Schedule “L”
MINUS
5c of Schedule “M-1 – Meals &
Entertainment
Note: Use only if borrower owns 100% of the corporation
• Review other deductions.
• Amortization cannot be added back
• Net operating loss can be added back if carry forward is from a year that is not included in your income average.
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Schedule L – Line 17
Deduct meals and
entertainment exclusion
15
Name, address , employment ID# and most important date XXXX
This will indicate if the business is the initial or final return or if they have changed the business name or address
Corporate officer’s income Depreciation/Depletion can be added back
To cash flow Ordinary income
16
Line 20
Pay attention to debts that need to be repaid
Line 17 mortgages, notes, bonds payable in less than 1 year.
Do not forget to review Line 19 , loans from shareholders, and line 7, loans from
shareholders
17
Income is derived from:
Line 21 plus Line 14 and 15 Minus Schedule L Line 17 Minus 3b of Schedule “M-1”
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This K-1 is associated with 1120S.
1120S
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The 1040’s in relationship to the Corporation, Partnership or LLC
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Since all income from a business is reported on the individual tax return, ask the following questions:
1. Did the borrower provide all of the schedules, income documentation and business returns?
2. In review of these documents can you determine if the business has the ability to continue generating income?
3. Are there any loans due with-in the year?
4. If so, what is the source to pay these loans? Will it deplete the cash sources?
5. Has our borrower, or others with-drawn cash from the company? If so, what was the purpose? How will it affect the income?
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Corporate wages are reported on a W-2
Partnerships, multi-member LLC, and S Corps income is reported on Schedule “E”
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Net Loss Carry-Over
• Determine where this loss came from. If the loss occurred prior to the years you are averaging it can be added back.
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The K-1 income is reported on schedule E; always use the actual K-1 or the business return to calculate, not Schedule “E”
Partnership, S Corporation and Multi-member LLC
Income
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Analyzing the Individual Tax Returns The 1040s
When do you use Tax Returns to analyze income?
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The Self-Employed Borrower
Definition:
An individual who has a 25% or greater ownership interest in a business.
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Definition:
An individual that receives income based on a percentage of their sales or production.
A number of factors need to be consider in analyzing a Commissioned Borrower.
o Is the commission income “consistent and on-going”?
o Has the commissioned income been received for a minimum of 2 years?
o Are there any 2106 (non-reimbursed employee expenses) deducted?
The Commissioned Borrower
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The Independent Contractor, Laborer, Union Employee
Definition: Any one who works a temporary job, in the construction business, landscaping business, a union worker or one who works for a variety of employers.
o
A number of factors need to be analyzed:
o
Document the income reported on the 1040s with W-2s and/or 1099s. Check Line #7, 21 or on the Schedule C.
o
Check Line #19 for unemployment compensation. Does this make sense?
o
Does the borrower write off 2106 expenses?
o
Make certain you also document year to date earnings
28
The Borrower who works for a Family business:
Definition: Any one who works for a family member or in a family business.
A number of factors need to be analyzed:
o
Determine if the borrower owns an interest of 25% or more in the business.
o
Verify how the borrower is paid: W-2 or 1099?
o
Does the borrower declare income on Line #7 or on a Schedule C or Schedule E?
o
Does the borrower have 2106 expenses?
o
Are any of the borrower’s debts (i.e., auto, credit cards) paid by the business?
o
Always obtain two years tax returns regardless of AUS findings and average income
o
Is the income consistent?
29
This is considered your “index”. All schedules indicated on page 1 must be provided
Does the information match the 1003?
30
Line 7- Wages earned, documented with a W-2
o If the borrower is a sole
proprietor, he can not pay himself a salary.
o If the borrower is a partnership he can receive a salary, which will be
reported on the K-1.
o If the borrower is an owner in a corporation, his salary will be shown on the W-2
If the borrower receives alimony, this will be found on Line 11.
31
Remember- If using interest and dividends for income
o The assets must still be available
o The assets must not be used to close the loan
Line 8a- Taxable Interest Line 8b- Tax-exempt Interest Line 9a- Ordinary dividends Line 9b- Qualified dividends
Only 9a can be used for qualifying income-the figure in 9b is included in 9a
32
Schedule “B” is only required if income exceeds $1500.00
Line 12- Schedule “C”- Sole Proprietorship
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Line 13- Capital Gains
It must be consistent and on-going for a minimum of 2 years. 2 year average required for qualifying income. The borrower must have “like kind” assets verified.
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Line 15a- IRA distributions
If the borrower is retired, this might to be a way to supplement their income.
o You must determine if the
assets are still available, and will be consistent and on-going for a
minimum of 3 years. You must determine how these funds are distributed and to verify it is not a one time distribution.
o Regular monthly distribution.
Line 16a- Pensions and Annuities:
o To use this income, you must document that there are sufficient funds to be drawn over a 3 year period. You must determine how these funds are distributed.
Pensions and Annuities are documented with a 1099-R.
o Regular monthly distributions required.
35
Line 17- Income from rentals, royalties, partnerships, S-
Corporations and Trusts
36
Line 18- Farm Income
o Determine if this income comes from subject property.
o Determine if this is
consistent and on-going, or a one time income/expense
37
Line 19- Unemployment compensation
o Determine if it is
consistent with the borrower’s job
o Determine if it is consistent with the loan
application- is there a job gap?
38
Line 20a- Social Security Income There are times when this income is taxable; therefore before you gross it up you must determine if it has been taxed The Social Security Income that is taxed will appear on Line 20b and will be included in the right column to be added in to one’s income
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Line 21 other income - You must determine if this income is
consistent and on-going, if it is a stable source of income, and how it is being paid.
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This is a good place to verify
additional information about your borrower. For instance:
o Lines 27,28, & 29 directly relate to a self-employed borrower.
o Some items are a one-time expense
o Alimony- Is it listed on your 1003?
o Student Loan Interest.
41
This schedule shows borrower’s additional expenses
Mortgage interest
Unreimbursed employee expenses
Check to see if these expenses apply
42
If using Dividend and/or Interest income in
qualifying, make certain the borrower has the assets, and they are not being used to close the loan.
Part I – Interest Part II - Dividends
If the borrower
received income from
“notes”, this where you will find the income.
43
Make certain the business name, address, the borrower’s name and SS# is the same as the 1003.
Part I - Income Part II - Expenses
Make certain income on line # 31 shows on page 1 of the 1040.
44
Since this schedule is for a sole proprietorship, our borrower is responsible for all debts
associated with the business.
See Line # 16a and 16b Depreciation: Add
Line 12 + Line 13/44 – Line 24b + Line 31= Net Profit Additionally, if you can
determine the borrower’s use of home applies, Line 30 can be added back to the equation on conventional loans only.
45
Depreciation:
Add back to Total Income any depreciation reported on Schedule “C”. Vehicle
depreciation can be calculated one of two ways- by using the standard mileage deduction or actual depreciation expense.
If the borrower used the standard mileage deduction, multiply the business miles driven by the depreciation factor for the appropriate year and add the calculated amount of the borrower’s cash flow.
Tip: These rates do not apply for any year in which the actual expense method was used.
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Year(s) Depreciation Rate per Mile
2010 $.23
2008-2009 $.21
2007 $.17
2005-2006 $.16
A break-down of Cost of Goods and Expenses.
Amortization cannot be added back
47
NOTE:
Capital gains or losses that are one time transactions should not be used. Only recurring gains and losses consistent over a period of time may be considered.
The Borrower must have sufficient remaining like assets.
48
Schedule E
There are 2 pages to this schedule.
Page 1 addresses Rents and Royalties.
Income is taken from:
Line 3 + 9 + 12 + 16 – 19 / 12
Then use full PITI payment in E3 and qualifying ratios
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Royalties
Income is taken from Line 4 - 20.
The source of these royalties must be noted as income on the 1003.
It must be verified that this income will continue for a minimum of 3 years.
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Page 2 of Schedule E
Part I – Partnerships and/or S- Corporation
Part II – Estates and Trusts
All partnerships, S-Corps, estates and trusts have a K-1.
This must be filed with the 1040s, even if the partnership, S-Corp, estate or trust tax returns have not been filed.
51
Income is reported on Page 1
Income for Part I is taken from line 32
Income for Part II is taken from line 37
52
Schedule F is farm income derived from farm animals or products.
Make certain that the location is not the subject property.
Determine that this is not a one time sale of a crop or farm animal.
Income is taken from line 36 and if there is depreciation, add back line 16.
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Break-down of sales and expenses
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A Form to Assist in Analyzing Income
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If you need a copy of this form:
• Check Credit Policy Forms Section 12
• Check FNMA web-site Form 1084 Cash Flow Analysis
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Helpful Charts And
Red Flag Check List
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