Beyond the Guide: A Deep Dive into Mortgage Underwriting - The Liquidity Test for 1065 and 1120S Borrowers
One of the tests that a competent underwriter will perform when underwriting a self-employed borrower who files either as a Partnership (1065) or an S-Corp (1120 S). A K-1 is a promise on paper. It says the borrower’s share of the business earned a certain amount of income. It does not say the borrower can actually get at that money. For self-employed borrowers who file as a partnership (Form 1065) or an S corporation (Form 1120S), the liquidity test is how an underwriter finds out whether the “paper income” is real income the business can afford to pay out.
Skip the test, or run it carelessly, and the loan is qualifying a borrower on earnings that may be stuck inside a business that cannot spare a dime. That is the kind of defect that surfaces at post-closing review, not at the closing table.
Underwriting guidelines change rapidly. For the most up-to-date information, please refer to the Fannie Mae Selling Guide at Selling Guide | Fannie Mae or for Freddie Mac at Guide Home. The section numbers below reflect the current Selling Guide, which has been renumbered over the years.
When the Test Applies: Distributions or Liquidity
Under B3-3.6-07, Income or Loss Reported on IRS Form 1065 or IRS Form 1120S, Schedule K-1, K-1 income may be included in the borrower’s cash flow provided the lender can confirm that the business has adequate liquidity. The Guide gives the lender two ways to get comfortable:
A documented, stable history of cash distributions. If the Schedule K-1 reflects a documented, stable history of receiving cash distributions of income from the business, no further liquidity or access documentation is required.
A liquidity test. Without that distribution history, the lender must confirm adequate business liquidity.
In other words, the liquidity test is not an extra hurdle for every self-employed borrower. It is the fallback when the K-1 income has not been proven to leave the business. Lenders should still document which path they took and why.
A few related points to keep straight:
Guaranteed payments: If the borrower has a two-year history of receiving “guaranteed payments to the partner” from a partnership or an LLC, these can be added to cash flow.
Ownership of 25% or more: The analysis of partnership and S corporation returns calls for a business cash flow analysis at this level, and the borrower’s share is based on the ownership percentage shown on the K-1 (B3-3.7-01 and B3-3.7-02). Borrowers with less than 25% ownership fall under B3-3.4-19, Schedule K-1 Income <25% Ownership, which has its own documentation rules.
Business returns: The lender generally needs the most recent two years of business federal income tax returns (Form 1065 or Form 1120S) unless the requirements to waive business returns are met, or the one-year alternative in B3-3.5-01 applies.
The Two Ratios: Quick vs. Current
The Guide does not hand lenders a single mandatory formula. The lender may use discretion in choosing the method and may use a generally accepted formula that measures business liquidity when business returns are provided. Two ratios are named:
Quick Ratio (Acid Test): (current assets - inventory) ÷ current liabilities. The Guide describes it as appropriate for businesses that rely heavily on inventory to generate income, because inventory is not cash and may take time to turn into it.
Current Ratio (Working Capital): current assets ÷ current liabilities. The Guide notes it may be more appropriate for businesses that do not rely on inventory to generate income, such as many service businesses.
The benchmark: a result of one or greater is generally sufficient to confirm adequate business liquidity. A result below one is not an automatic failure, because lenders may support adequate liquidity using alternative methods with a documented rationale. But “documented rationale” means exactly that. A file with a ratio of 0.6 and no explanation is a QC finding waiting to happen.
Where the Numbers Come From
On both Form 1065 and Form 1120S, the balance sheet figures come from Schedule L, which lists assets and liabilities at the beginning and end of the tax year. Current assets typically include cash, trade notes and accounts receivable, inventories, and other current assets. Current liabilities typically include accounts payable, mortgages, notes, and bonds payable in less than one year, and other current liabilities. Some smaller entities are not required to complete Schedule L, so when it is blank the file needs a balance sheet from the business to run the test.
Two cautions for underwriters. First, use the figures that match the tax year of the income being used. Second, if a year-to-date balance sheet or profit and loss statement is in the file, check it against Schedule L for obvious changes, such as a large new note payable or a big drop in cash.
Putting Numbers to It: Two Illustrative Businesses
The figures below are hypothetical and are shown only to illustrate the math. Both borrowers own 50% of an S corporation, and both show healthy K-1 income. The ratios tell very different stories.
Business A, consulting firm: cash $85,000; accounts receivable $120,000; inventory $0; other current assets $5,000. Total current assets $210,000 and total current liabilities $150,000. Current ratio 1.40; quick ratio 1.40.
Business B, equipment distributor: cash $40,000; accounts receivable $80,000; inventory $180,000; other current assets $0. Total current assets $300,000 and total current liabilities $200,000. Current ratio 1.50; quick ratio 0.60.
Business A has no inventory, so the two ratios match. At 1.40, the business comfortably clears the benchmark of one and the underwriter can document the result.
Business B looks fine on the current ratio at 1.50, but most of its current assets are inventory. Because the business relies on inventory to generate income, the quick ratio is the better measure, and at 0.60 it falls short of one. That does not automatically disqualify the income, but the lender would need a documented rationale, such as a documented, stable history of cash distributions on the K-1 or other analysis supporting the business’s ability to pay out income, before using it.
The lesson: the ratio you choose should match how the business actually makes money, and the file should say why.
Where QC Finds the Defects
The liquidity test is easy to run and easy to run badly. A QC review should look for each of these:
No test and no distribution history. K-1 income was used, but the file shows neither a documented, stable history of cash distributions nor a liquidity calculation.
Wrong ratio for the business. The current ratio was used for an inventory-heavy business, hiding a weak quick ratio.
Mismatched tax year. The balance sheet figures come from a different year than the income being used.
Below one with no rationale. The ratio is under one and the file offers no documented rationale for accepting it.
Math errors. Current liabilities were pulled from the wrong lines, or inventory was left in the quick ratio numerator.
Ignoring short-term debt. Notes and mortgages payable in less than one year were not considered in the cash flow analysis, even though they affect both the ratio and the income.
Stale or missing business returns. The file does not contain the business returns the Guide requires, and no waiver applies.
The “Why” Behind the Liquidity Test
Why does a K-1 need a second look? Because taxable income and spendable cash are two different things. A business can show strong earnings and still have its cash tied up in receivables, inventory, or short-term debt. If the borrower qualifies on income the business cannot afford to distribute, the borrower’s real capacity is lower than the file says, and that is the kind of defect that leads to “buy-back” risk on the secondary market. The liquidity test is a simple, inexpensive check that closes that gap.
The Commonwealth Group: Precision. Integrity. Results.
Self-employed files are where good underwriting earns its keep. At The Commonwealth Group, our contract underwriting teams read the business returns, pick the right ratio for the business, and document the rationale so the income you use at underwriting holds up at post-closing review. We do not just follow the guide; we know what to do when the guide is not enough.
Ready to go beyond the guide?
Contact Martin Luplow at The Commonwealth Group – info@thecommonwealth.net for more information on what our team of professionals in processing and underwriting can do for your company.
The Commonwealth Group – Innovative Services for the Mortgage Industry
West Beibers, CMB, AMP, CRU
Chief Executive Officer
The Commonwealth Group Companies