I've been asked to publish this again so here it is. The reference for this post is FHA's website.
RE: FHA SELF-EMPLOYED BORROWERS
A borrower with a 25 percent or greater ownership interest in a business is considered self-employed for FHA mortgage loan underwriting purposes. The following conditions apply to underwriting self-employed borrowers:
A. Minimum Length of Self-Employment. Income from self-employment is considered stable and effective if the borrower has been self-employed for two or more years. The high probability of failure during the first few years of a business makes the following requirements necessary for individuals who have been self-employed less than two years:
1. Between One and Two Years. An individual self-employed between one and two years must have at least two years of documented previous successful employment (or a combination of one year of employment and formal education or training) in the line of work in which the borrower is self-employed or in a related occupation to be eligible.
2. Less than One Year. The income from a borrower self-employed less than one year may not be considered effective income.
B. Documentation Requirements. The following documents are required from self-employed borrowers:
1. Signed and dated individual tax returns, plus all applicable schedules, for the most recent two years.
2. Signed copies of federal business income tax returns for the last two years, with all applicable schedules, if the business is a corporation, an "S" corporation, or a partnership.
3. A year-to-date profit-and-loss (P&L) statement and balance sheet.
4. A business credit report on corporations and "S" corporations.
C. Analyzing Income. The lender must establish the borrower’s earnings trend over the previous two years but may average the income over three years, if all three years’ tax returns are provided. If the borrower provides quarterly tax returns, the analysis can include income through the period covered by the tax filings. If the borrower is not subject to quarterly tax filings or does not file quarterly returns (Form IRS 1040 ES), the income shown on the P&L statement may be included in the analysis, provided the income stream based on the P&L statement is consistent with the previous years’ earnings. If the P&L statements submitted for the current year show an income stream considerably greater than what is supported by the previous years’ tax returns, the analysis of income must be predicated solely on the income verified through the tax returns. To determine if the business can be expected to continue to generate sufficient income for the borrower’s needs, lenders must analyze carefully the business’s financial strength, the source of its income, and the general economic outlook for similar businesses in the area. Annual earnings that are stable or increasing are acceptable.
Conversely, a borrower whose business shows a significant decline in income over the period analyzed is not acceptable, even if current income and debt ratios meet our guidelines.There are four basic types of business structures: sole proprietorships, corporations; limited liability ("S" corporations); and partnerships. Each type requires slightly different forms of analysis. The following provides additional information on analyzing tax returns:
1. Individual Tax Returns (IRS Form 1040). The amount shown on the IRS Form 1040 as "adjusted gross income" either must be increased or decreased, based on the lender’s analysis of the individual tax returns and any related tax schedules. Particular attention must be paid to the following:
a. Wages, Salaries, and Tips. An amount shown under this heading may indicate that the individual is a salaried employee of a corporation or has other sources of income. It also may indicate that the spouse is employed, in which case the income must be subtracted from the adjusted gross income in the analysis.
b. Business Income or Loss (from Schedule C). The sole proprietorship income calculated on Schedule C is business income. Depreciation or depletion may be added back to adjusted gross income.
c. Rents, Royalties, Partnerships, Etc. (from Schedule E). Any income received from rental properties or royalties may be used as income after adding back any depreciation shown on Schedule E.
d. Capital Gain or Loss (from Schedule D). This transaction generally occurs only one time, and it should not be considered in determining effective income. However, if the business has a constant turnover of assets resulting in gains or losses, the capital gain or loss may be considered in determining the income, provided the borrower has at least three years’ tax returns evidencing capital gains. An example includes an individual who purchases old houses, remodels them, and sells them for a profit.
e. Interest and Dividend Income (from Schedule B). This income, which is taxable and tax-exempt, may be added back to the adjusted gross income only if it has been received for the past two years and is expected to continue. (If the interest-bearing asset will be liquidated as a source of the cash investment, the lender must adjust accordingly.)
f. Farm Income or Loss (from Schedule F). Any depreciation shown on Schedule F may be added back to the adjusted gross income.
g. IRA Distributions, Pensions, Annuities, and Social Security Benefits. The non-taxable portion of these items may be added back to the adjusted gross income, if the income is expected to continue for the first three years of the mortgage.
h. Adjustments to Income. Certain adjustments to income shown on the IRS Form 1040 may be added back to the adjusted gross income. Among these adjustments are IRA and Keogh retirement deductions, penalties on early withdrawal of savings, health insurance deductions, and alimony payments.
i. Employee Business Expenses. These expenses are actual cash expenses that must be deducted from the borrower’s adjusted gross income.
2. Corporate Tax Returns (IRS Form 1120). Corporations are state-chartered businesses owned by their stockholders. Compensation to its officers, generally in proportion to the percentage of ownership, is shown on the corporate tax returns and will appear on individual tax returns. If the borrower’s percentage of ownership is not shown, it must be obtained separately from the corporation’s accountant, with evidence that the borrower has the right to those funds. Once the adjusted business income is determined, it should be multiplied by the borrower’s percentage of ownership in the business. In analyzing the corporate tax returns, lenders must adjust for the following:
a. Depreciation and Depletion. The corporation’s depreciation and depletion must be added back to after-tax income.
b. Taxable Income. Taxable income is the corporation’s net income before federal taxes. It must be reduced by the tax liability.
c. Fiscal Year vs. Calendar Year. If the corporation operates on a fiscal year that is different from the calendar year, an adjustment must be made by the lender to relate corporate income to the individual tax return.
d. Cash Withdrawals. The borrower’s withdrawal of cash from the corporation may have a severe negative impact on the corporation’s ability to continue operating.
3. "S" Corporation Tax Returns. An "S" corporation is generally a small, start-up business, with gains and losses passed on to stockholders in proportion to each stockholder’s percentage of business ownership. The income for the owners comes from W-2 wages and is taxed at the individual rate.The "compensation of officers" line on the IRS Form 1120S is transferred to the borrower’s IRS Form 1040. Both depreciation and depletion may be added back to income in proportion to the borrower’s share of income. However, income also must be deducted proportionately by the total obligations payable by the corporation in less than one year. The borrower’s withdrawal of cash from the corporation may have a severe negative impact on the corporation’s ability to continue operating and must be considered in the analysis.
4. Partnership Tax Returns. A partnership is formed when two or more individuals form a business and share in profits, losses, and responsibility for running the company. Each partner pays taxes on his or her proportionate share of the partnership’s net income. Both general and limited partnerships report income on the IRS Form 1065; this form must be reviewed by the lender to assess the viability of the business. The partner’s share of income is carried over to Schedule E of IRS Form 1040. Both depreciation and depletion may be added back to income in proportion to the borrower’s share of income. However, income also must be deducted proportionately by the total obligations payable by the partnership in less than one year. The borrower’s withdrawal of cash from the partnership may have a severe negative impact on the partnership’s ability to continue operating and must be considered in the analysis.
EMPLOYMENT BY FAMILY-OWNED BUSINESSES. Borrowers employed at businesses owned by their family member(s) are required to provide additional income documentation. These borrowers must provide the normal verification of employment, pay stubs, and evidence that they are not an owner of the business. This evidence may include copies of the borrower’s signed personal tax returns or a signed copy of the corporate tax return showing ownership percentages.
Source - www.FHA.gov
