S-Corporation Income with a Declining Year and PPP Forgiveness
Your borrower owns 100% of an S-corporation. The 2023 and 2024 returns show: 2023 W-2 wages $45,000, K-1 ordinary income $70,000, depreciation $10,000, business use of home $3,600, and PPP loan forgiveness of $15,000 included in ordinary income. 2024 W-2 wages $45,000, K-1 ordinary income $52,000, depreciation $12,000, and business use of home $3,600. The borrower takes $40,000 in distributions each year and has no other income. Proposed housing payment is $2,400; monthly debts are $600. The loan is conventional, and the AUS findings are automated. The borrower says the 2024 decline is temporary because a major client paused orders, but he has no written contract or letter confirming the work will resume.
1. Calculate qualifying income for 2023 and 2024, and explain each adjustment.
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For 2023, start with W-2 wages of $45,000 and K-1 ordinary income of $70,000. Add back depreciation of $10,000 and business use of home of $3,600 because they are non-cash deductions. Subtract the $15,000 PPP forgiveness because it is nonrecurring and was included in ordinary income; counting it would overstate sustainable income. That gives $45,000 + $70,000 + $10,000 + $3,600 - $15,000 = $113,600. For 2024, add $45,000 + $52,000 + $12,000 + $3,600 = $112,600. Distributions are not added because they are draws of already-counted profit. The two-year average is $113,100, or $9,425 per month. With $3,000 in monthly obligations, the DTI is about 31.8%. Using the lower 2024 figure gives $9,383 per month and about 32.0% DTI.
2. Which income figure should you use given the decline, and what documentation would support it?
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Do not automatically use the two-year average just because the DTI passes. When self-employment income is declining, the underwriter must analyze whether the decline is likely to continue. The borrower's statement that the decline is temporary is not enough without documentation. If he can provide a signed contract, purchase order, client letter, or other evidence that the major client's orders are resuming, the average may be acceptable with a written explanation. If he cannot, use the lower 2024 income of $112,600 to be conservative. Either way, document the trend analysis, the reason for the decline, and why the selected income is stable. Do not count the PPP forgiveness or the distributions as recurring income.
3. What if the 2024 K-1 also includes a $20,000 one-time gain from selling equipment? How would that change the analysis?
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The $20,000 equipment-sale gain is nonrecurring and should be subtracted from 2024 ordinary income before calculating qualifying income. That would reduce 2024 income from $112,600 to $92,600. The two-year average would then be $103,100, or about $8,592 per month, and the DTI with $3,000 in monthly obligations would rise to about 34.9%. The lower-year approach would use $92,600, or $7,717 per month, producing a DTI of about 38.9%. The loan may still be approvable, but the underwriter must document the one-time nature of the gain and use a consistent method. The key is to avoid counting a nonrecurring event as stable business income.