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When you’re applying for a business loan, you might feel as if lenders require a mountain of unnecessary paperwork before making a final decision. Some of those documents, including your annual tax return, contain information you might consider sensitive or personal. However, lenders have good reason for requesting this information. It protects them from taking on bad loans, and that, in turn, helps to keep your rates and fees down.
So, what information are they looking at on your tax return? Well, it could depend on the type of loan you’re applying for; however, much can either be taken directly from your return or inferred from the information contained in various line items.
The thing to remember is that your tax return is the most important document that banks and lenders need to have in order to determine your creditworthiness as a business owner.
Your annual revenue will probably be the first thing lenders notice on your tax return. If you submit returns for multiple years, they will be able to establish a pattern. If your reported revenue is stable or growing each year, it’s a good sign that you will be able to repay a small business loan. And, of course, lenders want to loan money to borrowers who are capable of making timely repayments.
If you’re a freelancer running a business by contracting services, copies of your 1099s may also be requested. Though this information is reported on the return, having copies of these forms from your clients helps to verify that the information you are reporting is accurate. It also gives lenders an idea of the stability of your client base.
Like revenues, losses are also reported on your tax return. Obviously, losses are red flags for lenders that signify you might not bring in enough income to qualify for the loan you want. You might still be able to secure a loan, but chances are your interest rate will be higher, and the total amount you are approved to borrow could be less than you need.
It’s important to note that tax deductions can dramatically affect reported income on your tax return. Accountants and bookkeepers who prepare your documents are trained to save you as much as possible on your taxes, and that often means minimizing your income. If you’re expecting to need a loan, you might have to omit certain deductions in order to show enough income to qualify for the loan.
At one time, loan officers might have suggested business owners amend their tax return in order to avoid a denial. However, as policies have changed an amended return in and of itself can be enough to trigger a loan denial.
As mentioned earlier, the type of loan product you’re applying for will have some bearing on what parts of your tax return are most relevant. For short-term lenders, your return will be used specifically to confirm your annual revenue. For long-term lenders, your return will also be used to confirm that your cash flow is greater than your monthly payment.
Generally speaking, lenders want to see a debt-service coverage ratio of 1.5 or greater, meaning your monthly cash flow needs to be 1.5 times greater than your monthly loan payment. While some lenders might consider a slightly lower debt-service ratio, anything less than 1.0 will almost certainly not be approved. For the best loan terms, you should shoot for a ratio of 2.0 or higher.
Now that you know what lenders will be looking for, you can make smarter business decisions and have some idea how likely you are to be approved for a loan before you start your application.