Chapter 32 — Key Takeaways

The one thing

A business owner's accountant is paid to minimize taxable income. An underwriter counts taxable income. Both are doing their jobs correctly, which guarantees that the number the borrower believes and the number that qualifies them will differ — and the loan officer is the only person in the transaction positioned to say so before it becomes a crisis.

The core claims

1. Self-employment underwriting is backward-looking because there is nothing else to look at. A W-2 borrower's income is a promise somebody else made. A business owner has no such promise, so the only evidence is a filed return that was deliberately compressed.

2. The structure determines the documents. Sole proprietorship → Schedule C on the personal return. Partnership → Form 1065 with a K-1. S-corporation → Form 1120-S with a K-1 and W-2 wages to the owner. C-corporation → Form 1120, with the owner's income appearing as W-2 wages and dividends. An LLC is a state-law entity, not a tax classification — always ask which return it files.

3. One principle governs every add-back. Add back what was deducted and did not leave the business; subtract what left the business and was not deducted. Learn the principle, not the list, because sooner or later a return will show you a line nobody put on any list.

4. Distributions are not income. A distribution is a transfer of already-taxed earnings. What it tells you is whether the owner is living off earnings or off capital — which is useful, and is not qualifying income.

5. A declining trend takes the lower year. You do not get to average a declining stream up. A decline needs an explanation that names a cause, supported by a year-to-date P&L. "My accountant found more deductions" explains nothing an underwriter can use.

6. Business funds require a question the balance sheet cannot answer alone. After the money leaves, can the business meet its next payroll, its next tax deposit, and its next equipment payment without borrowing?

7. Never give tax advice. Describe the mechanism, hand the borrower the trade-off, and send them to their accountant. Never suggest amending a filed return.

8. When the agency analysis fails, say so and stop. Chapter 34 owns what exists beyond it. Do not manufacture an add-back you cannot defend.

The rule of thumb

Get the returns before the letter. Every self-employed borrower. Every time.

There is no version of this job in which a pre-approval issued on a conversation is worth the four days it saves.

The formula

$$\text{Qualifying income} = \frac{\text{business income} + \text{add-backs} - \text{subtractions}}{\text{12 or 24 months}}$$

with the denominator decided by the trend: 24 months when income is flat or rising (the conservative convention), and the lower figure — normally the most recent 12 months — when it declined.

The Fulton Avenue file, worked:

24-month average \$9,020.83** · most recent year alone **\$8,916.67 · income declined 2.3%, so the underwriter uses \$8,916.67**. The borrower's accountant told them **\$9,500. The gap is \$583.33 a month** — about **\$41,000 of house at a 45% back-end ratio.

Numbers worth remembering from this chapter

Key terms

self-employed borrower · sole proprietorship / Schedule C · partnership / Form 1065 · S-corporation / Form 1120-S · C-corporation / Form 1120 · K-1 · Cash Flow Analysis (Form 1084) · add-back · depreciation · depletion · amortization · meals and entertainment exclusion · nonrecurring income · business liquidity · profit and loss statement · accountant letter · business narrative

What you should be able to do Monday morning

Take a self-employed borrower's first call, ask the four questions that identify the structure and the documents, send one complete request list instead of five partial ones, complete a cash-flow analysis from the returns when they arrive, and call the borrower back the same day with a real number, the mechanism behind it, and no apology in your voice.