Best Practice: SBA Requirements for IRS Tax Transcripts

A crucial step of underwriting and closing an SBA loan is verification of the SBA applicant’s financial information and tax returns.  SOP 50 10 7.1 sets forth specific tax verification guidance and requirements at pages 72-74.  Read on to find out the who, what, when, why and how.

What is the purpose of SBA’s tax verification process?

SBA requires that SBA lenders verify financial information in order to (i) confirm that the applicant filed business tax returns and (ii) verify that the applicant’s financial statements that were provided to Lender match the tax returns that were filed with the IRS.  If a loan is underwritten based on certain financial information, it is important for Lender to verify if that financial information is reliable and accurate. Moreover, if an applicant has not filed its required federal tax returns, it is not eligible for SBA financing.

Which loans are subject to SBA’s tax verification process?

• For 7(a) loans of $500,000 or less, Lender must follow the same financial information verification process that it uses for its similarly sized non-SBA guaranteed commercial loans, a standard which has come to be known in the industry as “Do What You Do.” Regardless of Lender’s conventional requirements though, prior to first disbursement of loan proceeds, Lender must obtain tax transcripts or business tax returns to verify the applicant’s size.
• For 7(a) loans greater than $500,000 and for all 504 loans, prior to the first disbursement of loan proceeds, Lender must follow SBA’s tax verification process to obtain tax transcripts and verify them against the applicant’s financial information.
• SBA’s tax verification process applies to applicants that are required to file tax returns (so new businesses that are not yet required to file tax returns are exempt from this requirement).
• For a sole proprietorship, Lender must verify Schedule C of the individual’s tax returns.
• If the loan involves a change of ownership, Lender must verify the Seller’s business tax returns. If the loan involves the acquisition of a segment of Seller’s business, other forms of verification, such as sales tax payment records, may be used in lieu of tax transcripts.
• If the applicant is an Eligible Passive Company, then Lender should verify the Operating Company’s tax returns instead.

How many years of tax returns must be verified?

• If the NAICS size standard is being used to determine eligibility, Lender must verify the last three years of tax returns.
• If the alternative size standard is being used to determine eligibility, Lender must verify the last two years of tax returns.

In both cases, if the applicant has been operating for less than the required time frame, Lender must verify tax returns for all years the applicant business has been in operation.

What are SBA’s acceptable methods of tax verification?

• Lenders may use the IRS’s Income Verification Express Services (IVES) program which utilizes Form 4506-C from the taxpayer; or
• Lenders may submit Form 8821 to IRS. When using Form 8821, Lenders must request a transcript that contains any changes to the original tax return.  Form 8821 must also list the SBA Lender as the designee.  The applicant or applicant’s accountant or agent is not permitted to file their own Form 8821.

Whether Lenders use Form 4506-C or Form 8821, Lenders must retain the applicable form in their loan file.

Now what?  Can I proceed to close the loan?

• Any significant differences between the tax transcript and the tax return must be explained and resolved to the satisfaction of the Lender (and to SBA for non-delegated loans) before closing the loan.
• If the IRS has no record of the applicant’s tax returns, the loan must be canceled or the closing must be postponed until the issue is resolved.
• If three years of tax transcripts are required and the tax transcript from IRS shows “Record Not Found” for the middle year, but the Lender is able to verify tax returns for the first and third years, and the applicant provides a record of receiving a refund or paying taxes for the missing year, then the Lender can reasonably assume that the applicant filed the missing tax return and move forward with the loan closing after documenting its file with the steps it took.
• If the Lender does not receive the tax transcript or a response from IRS within 10 business days, the lender must re-submit Form 4506-C or Form 8821 to IRS with a “Second Request” notation in the top right hand corner. For delegated processing, Lender may decide to proceed to closing, but at its own risk!  If the delegated Lender closes and funds its loan and is later unable to obtain the tax transcript or reconcile the tax transcript against the tax returns, the loan will likely be subject to a full denial of the SBA guaranty if it defaults.

Why does all of this matter so much?

It is important for Lender to verify that the financial information used in underwriting the loan is reliable and accurate. Failure to verify financial information is a common reason for full denial of the SBA loan guaranty in early default loans (i.e. loans that default within 18 months of closing).  Adhering to SBA’s tax verification process is essential to ensure the SBA guaranty remains intact.  For questions regarding SBA’s tax transcript requirements or other underwriting and closing matters, contact the attorneys at Starfield & Smith at 215-542-7070 or email us at info@starfieldsmith.com.