In the Introduction, we listed the various types of business you may see when underwriting and documenting for a self-employed borrower. In this learning clip, the type of business we will focus on is the S corporation.

Please remember that you are responsible for determining if your borrower’s income documentation demonstrates that he or she will have the financial ability to repay the mortgage.

The following chart describes the tax reporting information and advantages/disadvantages of an S corporation.

Matt and his brothers

Matt is a correctional officer making $28,000 W-2 earnings. He is also a 27% limited shareholder in a motivational firm called The Three Brothers. The firm is set up as an S corporation. For 2005, the company reported total income of $26,500. The documentation level returned by Loan Prospector is Streamlined Accept.

Selected tax returns for Matt and The Three Brothers are provided for further clarification.

This is an example of the K-1 Matt received from his partnership, The Three Brothers. Box 1 indicates his income as a shareholder for this year.

If your borrower is also employed by a corporation (actively participates in the business), he may also receive a W-2 from them.

This is an example of an S Corp Return for The Three Brothers. Line 6 shows the total income for the business, but you need to determine Matt’s percent of the income/compensation. This information will be on his personal tax returns for the same year including Schedule K-1.

You will also need to review the business return to determine if the business has adequate liquidity to support withdrawal of earnings. Again, review the history of distributions and the S Corp’s financial position and liquidity to determine the overall ability of the business to support the borrower’s withdrawal of earnings.

This is page 2 of Form 1120 S showing business income that should match Page 1, line 21. Again, rechecking the number for consistency ensures less chance the returns are fraudulent or altered.

Page 3 would indicate any foreign transactions and other deductions. A lack of supporting schedules would be a red flag you would need to follow up on.

Page 4 shows the balance sheet for the business. Key items to address in your review include:

• Line 17 - Any mortgage or note payable in less than 1 year may significantly affect the financial operation of the business. Does the business have retained earnings or cash to pay off? If there is evidence that these liabilities regularly rollover and/or there are sufficient liquid business assets to cover them, no further documentation or consideration of impact on income is necessary.
• Line 3b under schedule M-1 - Include Travel and Entertainment Exclusion. Subtract meals and entertainment exclusion reported on Schedule M-1 of Form 1120S from the business income.

Another example of a rollover history is in Schedule L, where Line 20 is payable in 1 year or more. Since this appears to re-occur, you would not need to deduct this amount.

In this instance, there is a debt of $1100.00 to be paid off, and there is cash of $186,700.00. So there is more than sufficient funds to pay off the debt. We also have a Note that's rolling over. If this Note was to come due, would there be sufficient funds to pay it off? Yes, if you add the cash and the retained earnings, you will see there are sufficient funds and this company is considered solvent. [To play movie, click right blue arrow below]

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