S-Corp Owner: Declining K-1 Income and a Line-of-Credit Draw
Your borrower is a 60% shareholder in a specialty contractor and has applied for a $520,000 cash-out refinance at 80% LTV. The 1120-S returns show ordinary business income of $148,000 (2021), $121,000 (2022), and $86,000 (2023); the borrower also received W-2 wages of $60,000 each year. K-1 distributions were $40,000, $35,000, and $30,000. Retained earnings grew each year. In 2023 the company drew $75,000 on a revolving line of credit to cover slower receivables and owner distributions. The CPA letter states 2024 year-to-date revenue is down 14% and the line remains at $70,000. The borrower wants to qualify using $146,000 of 2023 income ($86,000 K-1 plus $60,000 wages) and has asked you to add back the $30,000 distribution. Proposed PITIA is $3,950 and other monthly debt is $1,150. Credit is clean and reserves after closing are $22,000.
1. Calculate qualifying income using (a) taxable income and (b) cash flow available to the borrower. Which figure do you use, and why?
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Taxable-income view: W-2 wages $60,000 + K-1 ordinary income $86,000 = $146,000, or $12,167 per month. Do not add the $30,000 distribution: S-corp distributions are a distribution of previously taxed earnings, not new income, and adding them double counts. Cash-flow view: $60,000 wages + $30,000 actual distributions = $90,000, or $7,500 per month. The remaining $56,000 of 2023 K-1 income was retained in the business and is not available to pay the mortgage unless the borrower can document a distribution without impairing liquidity. The $75,000 line-of-credit draw is a red flag because it funded owner distributions and slower receivables, meaning operations were not generating enough cash to support the reported income. The trend is also material: combined W-2 and K-1 income fell from $208,000 in 2021 to $146,000 in 2023, a 30% decline. A decline that large generally prevents simple averaging, so use the most recent year. I would underwrite to $90,000 unless sustainable access to retained earnings is documented. DTI at $90,000 is $5,100 / $7,500 = 68%; at $146,000 it is $5,100 / $12,167 = 41.9%. The choice determines approval.
2. What documentation would you require to resolve the line of credit and the declining revenue, and what would cause you to decline?
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Require 2024 year-to-date business P&L and balance sheet, 12–24 months of business bank statements, the line-of-credit notes and statements, an aged receivables report, business debt schedule, and a CPA letter explaining the draw, repayment terms, and whether the line is personally guaranteed. Also obtain 2024 YTD personal income evidence and updated personal tax returns if available. If the line is personally guaranteed, include its payment in the borrower’s debt. Decline or reduce the loan if 2024 revenue and cash flow continue below 2023, if distributions cannot be sustained at $30,000 or more, or if DTI exceeds the lender maximum using the $90,000 cash-flow figure. A CPA projection alone is not sufficient; the underwriter needs contemporaneous business records showing the trend has stabilized.
3. The CPA now says the $70,000 line will be repaid from a $95,000 receivable due in 60 days. Does that cure the income problem?
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No. A projected receivable is not current cash flow and cannot be added to qualifying income. Verify the receivable with the contract, invoice, and aging, and confirm whether it is collectible and already pledged to the line. Even if collected, repayment of the line restores the business balance sheet but does not prove that owner distributions of $30,000 are sustainable or that the 14% revenue decline has reversed. I would treat the receivable as a potential liquidity source only after it is collected and documented in business bank statements. Until then, underwrite to the $90,000 cash-flow figure. If that produces DTI above the lender maximum, the file should be suspended or declined, or the loan amount reduced.