The S-Corp Owner with a One-Time Equipment Gain
Marcus owns 100% of a small trucking company organized as an S corporation and is buying a $410,000 primary residence. His 2022 K-1 shows $92,000 of ordinary business income; his 2023 K-1 shows $154,000. The 2023 figure includes a $48,000 gain on the sale of a semi-tractor and $16,000 of depreciation; 2022 depreciation was $19,000. Gross revenue fell about 9% in 2023 after his largest customer cut its contract, though net income rose because of the equipment sale. Marcus takes $6,500 a month in distributions, which he calls 'his salary.' He also personally guaranteed a $2,100-a-month business auto loan that appears on his credit report and is paid from the company operating account; the 2023 business return lists the payment as an expense. He has $28,000 in reserves and wants the loan approved using 2023 income only, since it is the highest year.
1. Calculate Marcus's qualifying monthly self-employment income using a two-year average, and explain each adjustment you made.
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Work from the K-1 ordinary business income, then remove non-recurring items and add back non-cash deductions.
2022: $92,000 ordinary income + $19,000 depreciation = $111,000.
2023: $154,000 ordinary income − $48,000 one-time gain on the semi-tractor + $16,000 depreciation = $122,000.
Why each adjustment:
- Depreciation is added back because it is a non-cash expense that reduced the K-1 income but did not reduce the cash available to the owner. Note that depreciation is already deducted in arriving at ordinary business income, so adding it back restores cash flow; it is not double counting.
- The $48,000 gain is subtracted because it is a one-time sale of a business asset, not recurring operating income. Including it would overstate sustainable earnings. If the borrower regularly buys and sells equipment as part of the business, the analysis changes, but a single tractor sale is not recurring.
- Distributions are not added. The $6,500 monthly draw is a distribution of income already counted in the K-1. Adding distributions to K-1 income would double count the same dollars. Distributions are useful evidence that the business can support the owner, but they are not a separate income source.
Two-year average: ($111,000 + $122,000) ÷ 2 = $116,500. Monthly qualifying income = $116,500 ÷ 12 = about $9,708.
Document the business returns, K-1s, and a current year-to-date profit and loss statement. If the YTD statement shows earnings running materially below the 2022 level, the average is not supportable and the lower figure should be used.
2. Gross revenue declined 9% and the largest customer left. How should that affect the analysis, and could the lender rely on one year only?
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The revenue decline matters because self-employed income must be stable and likely to continue. But the analysis is not driven by gross revenue alone. After removing the one-time asset sale, adjusted income actually rose from $111,000 to $122,000, so on a cash-flow basis there is no decline. The correct conclusion is that income is not trending downward, but the cause of the revenue drop must be explained and documented.
Steps to take:
- Obtain a written explanation of the lost contract and evidence of replacement revenue (new customer contracts, invoices, YTD revenue).
- Obtain a year-to-date profit and loss statement and, if the business is a pass-through, a K-1 consistent with it.
- Compare YTD earnings to the same period last year. If YTD is running below the two-year average, use the lower, supportable figure rather than the average.
Can one year be used? Under many agency guides, a single year may be considered when the borrower has been self-employed for at least five years, the business is stable, the decline is attributable to a documented one-time event, and current YTD performance supports the higher figure. Here, however, the borrower wants to use 2023 because it is the highest year, and 2023 is the year distorted by the asset sale. That request should be denied on its own logic: the year he wants is the least representative year. The proper outcome is either the two-year average of adjusted income or the lower of the average and a well-supported current figure.
3. How should the $2,100 business auto loan be treated in the debt-to-income ratio?
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The loan is in the business's name but is personally guaranteed and appears on Marcus's credit report, so the default treatment is to count it as a personal obligation. The lender may exclude it only if it can document all of the following:
- The debt is a business obligation, and the business - not the borrower - has been making the payments.
- The payments are reflected as an expense on the business return, so they have already reduced the income used to qualify Marcus.
- There is a 12-month payment history from business funds (cancelled checks or business bank statements) showing the company paid it.
- Paying the debt does not materially impair the business's ability to continue operating and supporting Marcus's income.
Why the second point is critical: if the $2,100 was already deducted as a business expense before arriving at the $116,500 of qualifying income, counting it again in the DTI would double count the same obligation. Conversely, if the payment was not deducted on the return, excluding it would understate the borrower's obligations.
If the documentation is incomplete - for example, only three months of business bank statements, or payments made from the personal account - count the full $2,100 in the DTI. Do not accept a personal guarantee plus a credit report entry as proof that the business pays the debt. Whichever path is chosen, the file needs a written rationale so an auditor can follow the reasoning.