header

Types of Self Employed Business Structures

When attempting to qualify the self employed for a mortgage loan using full documentation (with tax returns) it helps to know the different types of business structures.

There are four principal self employed business structures:  

Sole Proprietorships: In a sole proprietorship, the individual owner has unlimited personal liability for all debts of the business. Since no distinction is made between the owner’s personal assets and the assets used in the business, creditors may take either (or both) to satisfy business obligations.  The success of this type of organization depends solely on the individual who owns it.  His or her death would terminate the business and place the assets into probate, delaying the disposition of the assets to creditors and heirs.  Business income or loss is "folded into" the individual owner’s tax return.  

Partnerships: A partnership is formed when two or more individuals form a business and share profits, losses, and responsibility for running the business.  In a general partnership, each partner is personally liable for the debts of the entire business and is responsible for the actions of every other partner.  A general partnership is dissolved immediately on the death, withdrawal, insanity, or insolvency of any of the partners—although the personal liability to partnership creditors exists even after the partnership is dissolved.  In a limited partnership, a limited partner has limited decision-making ability and his or her liability is limited to the amount he or she invested in the partnership.  A limited partner’s death, withdrawal, insanity or insolvency does not dissolve the partnership.  Individual partners pay taxes on their proportionate share of net partnership income at their individual tax rate.  

Corporations: A corporation is a state-chartered business that is owned by stockholders.  A stockholder is not personally liable for the debts of the corporation.  Although legal control of the corporation rests with its stockholders, they are not responsible for the day-to-day operations of the business since they delegate that responsibility to a board of directors and officers of the company.  Corporations must file corporate tax returns or report their income and losses.  Income to the officers is folded into the officer’s individual tax returns.  

“S” Corporations: An “S” corporation is generally a small, start-up business with a limited number of stockholders.  Business gains and losses are passed on to the stockholders.  Stockholders are taxed at their individual tax rate for their proportionate share of the ownership.  Income for an owner that comes from wages is folded into the individual’s tax return.  

Contact us now by filling out a quick form to help us understand your needs.

Understanding the different self employed business structures is fairly easy. Understanding how your loan is underwritten based on your business structure is complicated, but we have summarized Fannie Mae's guidance on the subject below. Once you read it you may realize why many self employed people choose a stated income loan or a no income verification loan for their mortgage needs.

EVALUATING INDIVIDUAL TAX RETURNS (IRS FORM 1040) FOR CONVENTIONAL LOANS PER FANNIE MAE

Schedule C (Profit or Loss from business): The Sole Proprietorship income (or loss) calculated on Schedule C is business income or loss.  Depletion and depreciation can be added back to the one's self employed income, while the 20% (or 50%, depending on year of return) Meal and Entertainment exclusion must be deducted from your qualifying income.   

Schedule D (Capital Gains and Losses): A capital gain or loss is generally a one-time transaction.  Therefore, it should not usually be considered as either a gain or a loss in determining the income.  However, if your business has a constant turnover of assets that produces regular gains and losses, the capital gain or loss may be considered. (An example of this is the person who buys old houses, remodels them and sells them for profit.) If you have operated in this manner over a period of time, we may develop an average of the past two years’ gains or losses for consideration in the income calculation.  If this source represents a substantial portion of your income, we will review tax returns for at least the last three years to get an accurate picture of the average earnings from this source.  For example, an asset sold during the year might be an income-producing asset, which could result in a reduction in future income after the sale.  

Rents (from Schedule E): Depreciation related to income (or loss) from rentals must be added back to net gain (or loss).  

Social Security Income: This income may be included if it will continue to be received for at least three years.  The non-taxable portion of these benefits must be added back to your adjusted gross income.

Adjustments to Income: Most of the income adjustments shown in IRS From 1040 can be added back to your adjusted gross income.  These adjustments include IRA deductions, the self-employed health insurance deduction, Keogh retirement plans, penalties on early withdrawal of savings, and alimony paid.  The adjustment for reimbursed business expenses represents an actual expense, so it should not be added back to the adjusted gross income.  Any alimony paid (although added back to adjusted gross income) must also be included as a monthly debt.  

Employee Business Expenses: These are actual out-of-pocket expenses that will be deducted from your adjusted gross income.  

Depreciation and Amortization (Form 4562): Amortization can be added back to adjusted gross income, but depreciation should not—since the adjustment would already have been made based on Schedule E or F of IRS form 1040.  

EVALUATING CORPORATE TAX RETURNS:

We will evaluate your corporate tax return to determine your share of a corporation’s after-tax income and non-cash expenses after obligations that are payable in less than one year have been deducted from the corporate tax returns.  Your percentage of ownership can usually be determined from the “compensation of officers” section of the corporate tax return.  If this information is not provided, we must obtain other evidence of your ownership before this income can be considered.  (A statement from your corporation’s accountant will be considered as acceptable evidence.)  Before using your share of a corporation’s funds to qualify you for the mortgage, we must verify your right to the funds by obtaining a corporate resolution or other comparable document that establishes that right.  
If the corporation operates on a fiscal year that is different from the calendar year, we must make time adjustments to relate the corporate income to the individual tax return (which is on a calendar year basis.) We will pay particular attention to the following items when evaluating income from U.S. corporation income tax returns (IRS form 1120) to make sure we develop the correct “adjusted” business income.

*Taxable Income:  This is the corporation’s net profit.  IT must be reduced by the corporation’s total taxes to determine after-tax income.

*Depreciation:  This non-cash expense must be added back to the corporation’s after-tax income.
 
*Depletion:  This non-cash expense must be added back to the corporation’s after-tax income.  

*Mortgage, notes, bonds payable in less than one year:  This figure, which is found on the corporation’s balance sheet, must be deducted from the corporation’s after-tax income since it is not available for distribution because the funds must be used to meet the next year’s obligations.  

Once the adjusted business income has been developed, it should be multiplied by your percentage of ownership in the business.  We would then subtract any dividend income from the business that you reported on your individual tax return to arrive at the total income available to you for qualifying purposes.  After the income available to you for qualifying purposes has been determined, we will re-evaluate the corporation’s overall financial position, using a comparative income analysis.  If you withdraw of cash it could have a severe negative impact on the corporation and may lead to negative cash flow.  When this occurs, it may not be possible to confirm stable, on-going income that is needed to approve the mortgage.

EVALUATING “S” CORPORATION TAX RETURNS:

We use a form provided by Fannie Mae to determine your share of the “S” corporation’s adjusted business income that will be available to qualify for the mortgage (if you are able to provide evidence that you have access to the funds).  “S” corporations pass gains and losses onto their shareholders, who are then taxed at the tax rates for individuals.  This income or loss, which is reflected on the U.S. Income Tax Return for an “S” Corporation (IRS Form 1120S), is transferred to Schedule E of the individual owner’s U.S. Income Tax Return (IRS Form 1040).  The primary source of income for an owner of an “S” corporation comes from W-2 wages, which can be traced to the “compensation of officers” line in IRS Form 1120S and is transferred to the individual owner’s IRS Form 1040..  Depreciation and depletion from the “S” corporation’s tax returns can be proportionately added back to your income – since they are actually non-cash expenses.  However, they first must be reduced by your proportionate share of the “S” corporation’s total obligations that are payable in less than one year.  (This will help us determine whether the business will be able to meet its short-term obligations.)

EVALUATING PARTNERSHIP TAX RETURNS

We use the same form provided by Fannie Mae to determine your share of the partnership’s adjusted business income that will be available for qualifying for the mortgage (if you are able to provide evidence that you have access to the funds). Both general and limited partnerships use the U.S. Partnership Return of Income (IRS From 1065) and the Partner’s Share of Income, Credits, Deductions, etc. (Schedule K-1) for filing federal income tax returns for the partnership.  The partner’s share of income is carried over to Schedule E of his or her U.S. Income Tax Return (IRS Form 1040).  Your proportionate share of depreciation and depletion can be added back to your income since they are non-cash expenses.  However, they must first be reduced by your proportionate share of the partnership’s total obligations that are payable in less than one year.  (This will help us determine whether the business will be able to meet its short-term obligations.)

EVALUATING PROFIT AND LOSS STATEMENTS:

Year-to-date income from a business can be used to qualify for a mortgage only if the income is in line with the previous year’s earnings for the business (or if audited financial statements are provided).  We will analyze the P & L to determine the portion of your business’ year-to-date income that can be used in qualifying you for a mortgage.  A typical Profit and Loss Statement has a format similar to Schedule C of the U.S. Income Tax Return (IRS From 1040).  Any salaries or draws received by you, as well as the allowable addbacks indicated in the “adjustment to income” section, may be added to the net profit.  However, only your proportionate share of these items can be considered in determining the amount that can be used to qualify you for the mortgage.

Contact us now by filling out a quick form to help us understand your needs.