S-Corporation Owner: Add-Backs, Distributions, and a Declining Year
Devon is a 100% owner of a consulting S-corporation and has been in business for six years. He is applying for a conventional purchase with estimated PITI of $2,950. His monthly obligations are a $465 car payment, $210 in student loans, and an $85 credit card minimum. The 2023 Form 1120-S shows ordinary business income of $96,000 on the K-1, W-2 wages of $60,000 paid to Devon, depreciation of $18,000, amortization of a client list of $4,000, a one-time $22,000 legal settlement expense from a resolved contract dispute, PPP loan forgiveness income of $35,000, and $40,000 in distributions. The 2022 return shows K-1 ordinary income of $72,000, depreciation of $15,000, W-2 wages of $60,000, and no PPP income. Year-to-date 2024 net income is running about 22% below the same period in 2023. The processor proposes counting the $40,000 in distributions as additional income to "give him room."
1. Calculate Devon's qualifying self-employment income using both years, itemizing each adjustment and explaining why it belongs.
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Start with the K-1 ordinary income and convert it to cash flow available to the borrower.
2023: $96,000 K-1 + $18,000 depreciation + $4,000 amortization + $22,000 one-time settlement expense − $35,000 PPP forgiveness income = $105,000. Add the $60,000 W-2 wages, which were already deducted in arriving at ordinary income, for $165,000.
2022: $72,000 + $15,000 depreciation = $87,000, plus $60,000 W-2 = $147,000.
Two-year average: ($165,000 + $147,000) ÷ 2 = $156,000 annually, or $13,000 per month.
Why each item. Depreciation and amortization are non-cash deductions, so they are added back. The settlement is added back only because it is genuinely non-recurring and the settlement agreement and a CPA letter support that; if it were an ongoing royalty or recurring litigation cost, no add-back. PPP forgiveness income is a one-time, non-operating item, so it is subtracted rather than counted as sustainable earnings. W-2 wages are added because they are real cash the business paid him and were subtracted before ordinary income was computed. Distributions are not income: they are a distribution of already-taxed profit, and counting both the K-1 earnings and the distributions double-counts the same dollars.
2. What is his DTI at the correct income, and what does the 2024 decline require you to do?
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DTI. Total obligations are $2,950 PITI + $465 + $210 + $85 = $3,710. At $13,000 per month, DTI is 28.5%.
If the processor's $40,000 of distributions were added, the file would show about $196,000 a year, or $16,333 per month, and a 22.7% ratio. That is not a conservative difference; it materially understates the borrower's leverage and would be an inflated income figure if it reached the underwriter or an investor.
The decline. A 22% year-over-year drop means the two-year average may not represent current earnings. Obtain the 2024 year-to-date profit and loss statement and balance sheet, typically covering at least the most recent quarter and signed by Devon, plus the most recent business and personal bank statements. If the trend holds, project 2024 at roughly 78% of 2023 cash flow, about $128,700 a year or $10,725 per month. DTI would then be 34.6%, still within a 43% guideline, so the loan can proceed. Document the reason for the decline, confirm it is not a permanent loss of a major client, and provide a written explanation. If the decline deepened or the P&L showed a loss, the underwriter could use the lower year or decline the income altogether.
3. What documentation should be in the file before the income is submitted to underwriting?
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Two years of signed personal federal returns with all schedules, plus two years of signed business returns (Form 1120-S) with K-1s, obtained through IRS transcripts (Form 4506-C) rather than borrower-supplied copies alone. A year-to-date profit and loss statement and balance sheet, signed and dated, covering the period through the most recent quarter. Evidence the business exists and is active: a business license, articles of incorporation, or a CPA letter confirming the business, ownership percentage, and that the borrower has been self-employed for six years. The settlement agreement and a CPA letter specifically identifying the $22,000 as a one-time expense, and documentation of the PPP forgiveness so the underwriter can confirm it is non-recurring. A written explanation of the 2024 decline, supported by the P&L. If the returns show a decrease large enough to change the analysis, a business narrative or letter from a third-party tax professional may be requested.
The originator never chooses the number. Present the calculation, the documentation, and the reasoning to underwriting, and never add distributions because the file "needs room."