Income or Loss Reported on IRS Form 1065 or IRS Form 1120S, Schedule K-1
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.
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.