You’ve diligently filed your business taxes for the year (well, we hope!) and saved the return for your files, and now you need to hand over a copy as part of your loan application.
But what exactly is the lender looking for on that tax return?
We’ll walk you through it.
Tax Returns are a Part of Most Loan Applications
You’ll need to provide a tax return—or several years’ worth of tax returns, if you’ve been in business for long enough—in order to apply for most loans.
But the way that the lender evaluates that tax return will depend on the type of loan you want.
If you’re applying for a short-term loan with a repayment period of 18 months, the lender will be much less interested in your tax return than in your bank statements and deposits. The debt won’t be outstanding for all that long, so these lenders just want to make sure that you’re pulling in enough revenue to cover your daily or weekly payments.
If you’re applying for a loan with a longer term, the lender will be interested in your business’s profitability. They want to make sure you’re making money over the long term, so your strong financial track record and balance of profits and losses will become more important.
Different Types of Tax Returns
If you’ve filed your business taxes at least once, you should be familiar with the type of tax return specific to your business’s legal structure.
Partnerships, which are owned and operated by at least two people, use a Form 1065.
Corporations are separate legal entities, which means that owners aren’t personally liable for the business.
C-Corporations use the regular Form 1120.
If you’re a sole proprietor, meaning you’re the single owner and operator of your company, your taxes will be a little different because your business taxes are attached to your personal taxes. This is actually literally true: you’ll need to attach a Schedule C to your personal income tax form.
And as a Limited Liability Corporation (LLC), which is like a combination of a partnership and corporation, your tax form will depend on the number of employees and how you’ve elected to treat your company. You can file like a sole proprietorship, a corporation, or a partnership. This information should be found on Form 8832, Entity Classification Election, which you filled out when setting up your company.
Depending on your business’s payment structures, you might need to provide other tax forms to the lender as well. For example, if you hire contractors or freelancers, you could be asked to show copies of your Form 1099-MISCs to verify the income you’ve paid to them.
What Do Lenders Care About?
So what are lenders looking for on those tax returns?
The first and most important thing is going to be that first section on any form: your income.
Tax returns will show a lender your annual revenue, which is a key metric for them in deciding whether or not they should offer you a loan.
“Income” here involves several different steps.
First, you’ll fill out your revenue—the total amount you pulled in from sales—and then you’ll subtract the cost of those goods and any returns in order to give you your gross profit.
This number will get added to any additional income you received, like from dividends or interest (on a Form 1120), to provide you with a total income figure.
Many lenders will ask you to submit returns from multiple years: the SBA, for example, asks for 3 years’ worth of tax returns for a 7(a) loan application.
This lets them see how your revenue has changed over time. If it’s been stable or increasing, that’s a good sign: it means that you’ll be more likely to make repayments on time.
Usually, lenders want to see a debt-service coverage ratio of at least 1.2, although 2.0 is even better. Your DSCR is the ratio of your cash flow to your monthly loan payment—so if you’re applying for a loan with a monthly payment of $1,000, your monthly cash flow (sales-expenditures) will need to be at least $1,200.
In the next part, you’ll fill out your deductions (or, as they’re called on Schedule C, your expenses).
These include payroll, interest, depreciation, benefits programs, licensing fees, and advertising: in other words, anything that costs your business money.
You’ll then have to subtract the deductions from your total income in order to come up with an “ordinary business income” or “taxable income” figure (the wording here depends on the form).
For some businesses—especially those with sharp accountants who’ve saved them money by generously claiming deductions—this final income figure will look low. It might even show a loss.
That’s great for saving tax money, but not always so great for loan applications, because you’ll want to show the highest possible income.
Luckily, this is where add-backs come into play.
For depreciation, interest, and compensation of officers, lenders will “add back” those deductions into your income.
“They’re always going to add those things back,” assures Kate Morgan, senior loan officer at Fundera. “The lenders understand that those things aren’t actually cash expenses.”
So it’s actually a win-win situation: the accountant gets to save you money by writing off these non-cash expenses as deductions, but the lender won’t subtract them from your income.
If you’re a sole proprietor who’s filled out a Schedule C, you don’t need to worry as much about these add-backs. Employer compensation won’t be taken into account, for example, because your business’s profit is going straight into your personal tax reporting. It’s much less complicated.
On a 1065 or an 1120, you’ll see a section called “Schedule L,” which is a balance sheet of your assets and liabilities.
Here, you’ll fill out information about your loans, your accounts payable, your real estate, your stock—any figures that express your assets, liabilities, and shareholder equity—at the beginning and end of the tax year.
The lender might look at this for verification, but if they care about this information, they’ll request a more detailed balance sheet from you. This is where bookkeeping software like QuickBooks, which keeps careful track of these figures, can prove extremely useful: it’ll let you find and print a balance sheet easily.
If you’re a corporation filling out an 1120, on line 12 you’ll see that you have to report “Compensation of officers.”
It will also refer you to Form 1125-E, which is a more detailed form that you’ll need to fill out and attach if your total receipts are over $500,000.
Also known as “Schedule E,” this form could be extremely important for loan applications because it will show ownership percentages. With many loan applications, the lender will look at the personal finances of any owner with more than 20% ownership. They might even require a personal guarantee.
The most important part of your tax returns, in the eyes of any lender, is going to be your income.
Lenders want to make sure that you’ll be able to make your payments on time without a problem for the length of the loan, which requires solid revenue and cash flow.
But it’s important to understand the other parts of the paperwork that you’re turning in as part of your loan application: your tax returns are one of the primary representations of your business and its finances.
The post A Quick Guide to How Lenders View Your Tax Returns appeared first on Fundera Ledger.
from Fundera Ledger https://www.fundera.com/blog/2016/05/24/how-lenders-view-tax-returns/