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ATTACHMENT 9-E INFORMATION FOR ANALYZING TAX RETURNS
FOR SELF-EMPLOYED APPLICANTS
Self-employed applicants must submit current documentation of the business’ income and expenses, including any applicable Federal tax returns that were filed with the IRS for the most recent two years in addition to year-to-date profit and loss and balance statements. Lenders are encouraged to use Fannie Mae Form 1084, Cash Flow Analysis, and Fannie Mae Form 1088, Comparative Income Analysis, to document a trend analysis for the applicant’s business. Lenders may use the Fannie Mae forms or any documentation that provides the same information. Regardless of the analysis method used, and the documentation prepared by the lender, the loan file must contain clear and sufficient support for the lender’s decision regarding the viability of the business and loan approval.
A. Individual Tax Returns (IRS Form 1040)
The amount shown on the IRS Form 1040 as “adjusted gross income” must be either 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:
x Wages, salaries, tips. If an amount is shown here, this may indicate the individual is
a salaried employee of a corporation or has other sources of income. It may also indicate the spouse is employed, in which case the income must be subtracted from the adjusted gross income in the analysis.
x 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.
x 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.
x Capital gain or loss (from Schedule D). This is generally a one-time transaction and
should not be considered in determining repayment 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 applicants have at least two years’ tax returns evidencing capital gains. An example would include an individual who purchases old houses, remodels them, and sells them for a profit.
x Interest and dividend income (from Schedule B). This income, both taxable and
tax- exempt, may be added back to the adjusted gross income only if it has been
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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.
x Farm income or loss (from Schedule F). Any depreciation shown on Schedule F
may be added back to the adjusted gross income.
x IRA distributions, pensions and 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.
x Adjustments to income. Certain adjustments to income shown on the IRS Form
1040 may be added back to the adjusted gross income. Among these are IRA and Keogh retirement deductions, penalties on early withdrawal of savings, health insurance deductions, and alimony payments.
x Employee business expenses. These are actual cash expenses that must be deducted
from the applicant’s adjusted gross income, if applicable.
B. U.S. Corporate Income 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 applicant’s percentage of ownership is not shown, it must be separately obtained from the corporation’s accountant with evidence the applicants have the right to those funds. Once the adjusted business income is determined, it is to be multiplied by the applicant’s percentage of ownership in the business.
In analyzing the corporate tax returns, lenders must adjust for the following:
x Depreciation and depletion. The corporation’s depreciation and depletion must be
added back to after-tax income.
x Taxable income. This is the corporation’s net income before federal taxes. It must be
reduced by the tax liability.
x Fiscal year versus 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.
x Cash withdrawals. The applicant’s withdrawal of cash from the corporation may
have a severe negative impact on the corporation’s ability to continue operating.
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C. “S” Corporation Tax Returns
An “S” corporation is generally a small, start-up business, with gains and losses passed onto 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 1120-S is transferred to the applicant’s IRS Form 1040. Both depreciation and depletion may be added back to income in proportion to the applicant’s share of income. However, income must also be deducted proportionately by the total obligations payable by the corporation in less than one year. The applicant’s withdrawal of cash from the corporation may have a severe negative impact on the corporation’s ability to continue operating which must be considered in the analysis.
D. 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 partnership pays taxes on his or her proportionate share of the partnership income.
Both general and limited partnerships report income on the IRS Form 1065, U.S. Return of Partnership Income, which 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 applicant’s share of income. However, income must also be deducted proportionately by the total obligations payable by the partnership in less than one year. The applicant’s withdrawal of cash from the partnership may have a severe negative impact on the partnership’s ability to continue operating that must be considered in the analysis.
E. LLC Corporation Tax Returns
A limited liability corporation (LLC) can be formed by one or more individuals. Owners in an LLC are referred to as members. A member of an LLC normally has at risk, only his or her share of capital paid into the business. Members are not personally liable for the debts of the LLC. There are three ways in which an LLC is taxed:
x Single-owner LLC. LLC owners are taxed on business profits each year on their
individual income tax returns. The IRS treats the LLC as a sole proprietorship. Profits are reported on Schedule C of an individual 1040 tax return.
x LLCs. The IRS treats the LLC as a partnership. The LLC prepares and files IRS
Form 1065, U.S. Return of Partnership Income, each year. LLC profits are allocated to each of the owners according to the profit-sharing arrangement set up in the LLC
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operating agreement. Each owner is given a Schedule K-1, which shows each owner’s share of LLC income. The owner then reports and pays taxes on this income on the owner’s 1040 income tax return.
x Check-the-Box Corporate Tax Treatment. Under these rules, any eligible business
can elect to be taxed as a corporation by filing IRS Form 8832, Entity Classification Election, and checking the corporate income tax treatment box on the form. After making this election, profits kept in the business are taxed at the separate income tax rates that apply to corporations.