I have recently run into a client’s situation that I thought bared discussion. Owners of a C Corp left profits in the corporation and did not distribute to themselves personally and it was a challenge qualifying them for a mortgage. There are different types of self-employed entities that someone may set up and in the mortgage lender’s eyes they are analyzed differently though a single theme is present throughout. If you don’t report the income to the IRS, we cannot use it.
Any individual who has a 25% or greater ownership interest in a business is considered to be self-employed. Lenders will require personal and business tax returns (if ownership is greater than 25%) to qualify a borrower in any of these types of entities.
A sole proprietorship is an unincorporated business that is individually owned and managed. The individual owner has unlimited personal liability for all debts of the business.
The income, expenses, and taxable profits of a sole proprietorship are reported on the owner’s IRS Form 1040, Schedule C, and are taxed at the tax rates that apply to individuals.
A partnership is an arrangement between two or more individuals who have pooled their assets and skills to form a business and who will share profits and losses according to predetermined proportions that are set out in the partnership agreement. A partnership may be either a general partnership or a limited partnership:
• General Partnership – Under a general partnership, each partner has responsibility for running the business, is personally liable for the debts of the entire business, and is responsible for the actions of every other partner (unless otherwise specified in the partnership agreement).
• Limited Partnership – Under a limited partnership, a limited partner has limited liability based on the amount he or she invested in the partnership, does not typically participate in the management and operation of the business, and has limited decision-making ability. Because limited partnerships often are formed as tax shelters, it is more likely that IRS Form 1065, Schedule K-1, will reflect a loss instead of income.
The partnership must report its profit or loss on IRS Form 1065 and each partner’s share of the profit or loss on IRS Form 1065, Schedule K-1; however, the partnership pays no tax on the partnership income.
Limited Liability Companies
A limited liability company (LLC) is a hybrid business structure that is designed to offer its member-owners the tax efficiencies of a partnership and the limited liability advantages of a corporation. The member-owners of the LLC (or their assigned managers) can sign contracts, sell assets, and make other important business decisions. The LLC operating agreement may set out specific divisions of power among the member-owners (or managers). Although the member-owners generally have limited liability, there may be some instances in which they are required to personally guarantee some of the loans that the LLC obtains. Profits from the operation of the LLC may be distributed beyond the pool of member-owners, such as by offering profit distributions to managers.
The LLC must report its profit or loss on IRS Form 1065 and each member-owner’s share of the profit or loss on IRS Form 1065, Schedule K-1; however, the LLC pays no tax on its income. Each member-owner uses the information from Schedule K-1 to report his or her share of the LLC’s net profit or loss (and special deductions and credits) on his or her individual IRS Form 1040, whether or not the member-owner receives a cash distribution from the LLC. Individual member-owners pay taxes on their proportionate share of the LLC’s net income at their individual tax rates.
An S corporation is a legal entity that has a limited number of stockholders and elects not to be taxed as a regular corporation. Business gains and losses are passed on to the stockholders. An S corporation has many of the characteristics of a partnership. Stockholders are taxed at their individual tax rates for their proportionate share of ordinary income, capital gains, and other taxable items.
The ordinary income for an S corporation is reported on IRS Form 1120S, with each shareholder’s share of the income reported on IRS Form 1120S, Schedule K-1.
Because this income from the distribution of corporate earnings may or may not be distributed to the individual shareholders, the lender should determine if the borrower received a cash distribution from the S corporation.
A corporation is a state-chartered legal entity that exists separately and distinctly from its owners (who are called stockholders or shareholders).
The distribution of profits earned by the business is determined by the owners of the corporation. However, the profits usually are filtered down to the owners in the form of dividends. Since a stockholder is not personally liable for the debts of the corporation, losses are limited to his or her individual investment in the corporation’s stock.
Corporations must report income and losses on IRS Form 1120 and pay taxes on the net income. The corporation distributes profits to its shareholders in the form of dividends, which it reports on IRS Form 1099-DIV. The shareholders must then report the dividends as income on their individual IRS Form 1040.
For questions or comments, please contact me at Ingrid.firstname.lastname@example.org or visit me at http://www.cobaltmortgage.com/ingridquinn.