An underwriter’s interpretation of Guaranteed Payments to Partners
You’ve just been made a Partner at your firm. Congratulations. You’ve billed thousands of hours (per year), clicked off the last light in the office more times than you want to remember, and jumped through hoops for your clients who stake their entire livelihood in your metaphorically calloused hands.
Because you can now truly afford it, you opt to purchase a home that was previously out of reach.
If you’ve found this article, I can assume you’re a good saver and you have equity for your down payment. You’re ready. Overly ready.
Except maybe you’re not.
In mortgage underwriting-land, when you alter your pay methodology, you also enter into a new classification of underwriting (there are several). It’s like going from softball to baseball. Different rules.
Fannie Mae sets the “homogenization” standard for most mortgage applications that are aimed at securitization (bundling) on the secondary market. Mortgages that don’t make the cut for the secondary market become portfolio loans. Write enough fixed-rate portfolio loans and the rates increase? Those companies self-asphyxiate.
Therefore the goal of any mortgage application is to fit the Fannie Mae box. Originate it. Move it along. Bundle it. Do it again.
So does an Underwriter consider “Guaranteed Payment to Partners” guaranteed?
The short answer to this question is “No”. Not at all.
The long answer begins with understanding that there is a difference between GAAP and FNMA underwriting guidelines. These principles and guidelines share many commonalities but also differ wildly on certain topics.
Related to the aforementioned query, we must first understand that there are only two main bases for non-passive employment calculations, a decision tree if you will. Salary/W2 or Self-employment (which also includes straight commission).
The definition of Self-Employment (“SE”) is most obvious but it is further tripped when the K1 (or Articles of Organization/Incorporation) shows the borrower as a 25% or greater shareholder. In those cases the borrower’s Salary/W2 status will be superseded and meet the definition of SE, triggering the analysis of Federal Corporate tax returns.
As this all relates to Guaranteed Payment to Partners (“GP2P”) we must first see if the borrower is less than 25% shareholder, or not.
If not, then the salary accrual rate is used. Anything beyond the salary accrual rate is taken in the form of historical averaging over the past 12 or 24 months depending on the type of additional earnings and probability of continuance. If a professional services firm employee is a Partner but NOT a 25% holder and received NO salary, just GP2P, then the GP2P calculation for underwriting would be a historical average.
If yes, then a GP2P to will be used in the income calculations, appearing on a K1, but only as an average of the most recent two tax years. It will not be considered Guaranteed as ALL self-employment income is averaged historically, not forward. The forward part of self-employment income is the probability that it is increasing (year over year), not declining. Sometimes the fact that it is not declining needs to be ascertained by Year-to-Date financials. There must also be a CPA letter stating that the business has a minimum of a two-year history and is currently still in operation.
In summary, for a > 25% partner, GP2P would appear as part of the K1 and would be averaged for 24 months.
For a < 25% partner the base salary would be used and the GP2P appearing in excess of the base would be averaged.
Walking across the line from Principal to Partner will, in the absence of continuing base salary, trigger a two+ year blackout period waiting on two full calendar years of K1 income to be averaged for qualifying underwriting income
Yeah, we agree with you. That’s not a fun conversation to have with a newly promoted partner looking to buy a home. This article was published in November 2022. Since changes occur to underwriting guidelines on a regular basis, please contact us by phone or email if this policy affects you directly so we can review if any options exist.