The Guide To Self-Employed Income Analysis – by a previous Mortgage Loan Underwriter and SVP of Operations…
If you’re self-employed, analyzing your income is essential for managing your finances and planning for the future. This guide will provide you with a comprehensive overview of self-employed income analysis, including how to calculate your net income, understand tax deductions, and plan for retirement.
Table of Contents
Understand the different types of self-employment income…
Self-employment income can come in many forms, including income from a sole proprietorship, partnership, LLC, or S corporation. It’s important to understand the differences between these types of income, as they can impact your tax obligations and financial planning. For example, income from a sole proprietorship is reported on a Schedule C form, while income from an S corporation is reported on the 1120s with a K-1 form.
Here are the additional Tax Form for Self-Employed Individuals:
There are mortgage loan opportunities for self-employed borrowers who have the ability to prove the stability of the company and income. It is a matter of how much income your 1040 (Schedule C), 1120, the 1120S, or 1065 income tax returns show for net income.
Fully understanding the type of income you have will help you accurately analyze your finances.
In addition to the different types of self-employment income, it’s also important to understand the difference between gross income and net income. Gross income is the total amount of money you earn from your business, while net income is the amount left over after deducting expenses.
It’s important to track both types of income, as they can impact your tax liability and financial planning. By tracking your gross and net income, you can better analyze your bottom line income that is used for qualifying for a mortgage, or type of financing. and make informed decisions about your business.
Self-Employment Rules *for mortgage lending specifically…
For a borrower to be considered self-employed, they own at least 25% of the company. This alone determines if the applicant is self-employed. That can be gathered from the client’s personal tax returns. As always within almost any business, some things stay the same, however, we know that usually, self-employed income does not.
Factors that are considered are the following:
- The stability of the self-employed income- has the client been self-employed for at least 2 years? If less than 2 years, is there a profit and loss statement? Does the statement indicate that the sales and/or services have increased from the previous year?
- Does the client have a history of being employed at some prior date in this field of work? Is there a history of self-employment for the client in another business?
- Is there a demand for this type of business in the area/city, in which the business is located?
- Does the area in general and the nature of the borrower’s business suit the surroundings?
- What is the financial stability and strength of the business?
- Does there appear to be an ability of the business to generate sufficient income in the future? Is it sufficient to enable the borrower to make the payments on the loan amount applied?
- Is there marketability of the property which is security for the mortgage conforming as a private residence? The property could need to be the source of repayment for the mortgage should the business fail.
Here we break it all down for you in The Ultimate Guide to Self-Employed Income Analysis
- Sole Proprietorship – Schedule C income with the 1040s
- U. S. Corporation – 1120
- U. S. -S Corporation – 1120S with K1’s -shareholders share of income, deductions, and credits
- U. S. Partnership – 1065 with K1’s which gives the Partner’s Share of Income, Deductions, Credits, etc.
There are additional schedules and forms to include 2106 employee business expenses, 4797- sale of business property, 6252- installment sale income, 8821-tax information authorization, 990- the return of organization exempt from Income Tax Form, and W-4 – employees withholding allowance certificate. Form 4506 -T is a request form for a transcript of Tax Returns. 4506 – is a request for a copy of tax returns.
The bank personnel, lender, or underwriter must evaluate each type of business a little differently, and here is why:
The Sole Proprietorship-
This is unincorporated and is individually owned, and managed and the owner has full responsibility and unlimited personal liability for the debts of the business. He/she is responsible for the entire operation. If the business fails, the borrower must replace his/her lost income and repay the business debts.
Creditors have the ability to take all assets for debts owed by the business, as there is no distinction between the owner’s personal assets and business assets.
The success of the business depends solely upon the owner’s access to capital and managing the aspects of the business, including how the business is run. If there are negligent management skills and the inability to obtain capital to keep the business going, there exists a possibility of failure and loss.
Partnership-
This kind of business includes two or more individuals who take their assets and abilities to form a business. They share the profits and losses per the predetermined proportions that are planned out in the partnership agreement. There are two types of partnerships, a general partnership, and a limited partnership.
General Partnership-
Each partner within this kind of partnership has the responsibility for managing the business and its affairs. Each partner is also liable for the debts of the entire business and is responsible for the actions of all partners. (This is not true if it is spelled out otherwise within the partnership agreement).
Upon the death, withdrawal, or insolvency of any of the partners, this partnership is automatically dissolved. The assets are automatically first applied to the creditors of the business. The partner’s personal assets will be first applied to their personal creditors. Any remaining assets being applied to business creditors.
Limited Partnership-
This of course mean limited liability based upon the amount he/she has invested in the partnership. They are not usually involved or participate in the management and/or operations of the business and they may have limited decision-making ability.
Normally a limited partnership usually has one general partner who manages the day-to-day business and is personally liable for the debts of the entire business. If one partner dies within a limited partnership; it does not dissolve the partnership.
Many times these kinds of partnerships are formed for a tax shelter and in these cases, the K-1 will indicate a loss instead of income. The loss will give the person only the ability to deduct based on the at-risk amount of his/her interest in the partnership.
What the review of the partnership returns must determine…
In mortgage lending specifically, the lender’s underwriter must evaluate the borrower’s financial risk by:
- evaluating if the applicant received any distributions from the partnership
- evaluate if the applicant has guaranteed loans made by the partnership outside of those considered nonrecourse debts
- evaluate the applicant’s share of non-cash expenses can be added back to the cash flow of the business
Limited Liability Companies (LLC)-
The LLC is a hybrid business structure that is made to offer its member-owners the tax efficiencies of a partnership and the limited liability advantages of a corporation.
The owners of the LLC or their manager may sign contracts, sell assets and make other important business decisions. The operating agreement usually sets out specific divisions of power for the member-owners or managers.
There are occasions the owners or members may have instances in which it is necessary for one to personally guarantee some of the loans that the LLC obtains. This occurs even though the member usually has limited liability. The profits from the operations of the business of the LLC are sometimes distributed beyond the members and offered to the managers.
The LLC pays no taxes on its income. Each owner or member of the LLC uses Schedule K-1 to report his/her share of the LLC’s net profit or loss. This is along with special deductions and credits on his/her individual 1040. Each member or owner of the LLC will pay taxes based on their proportionate share of the LLC’s net income at their individual tax rate.
The Underwriter must evaluate the following for the LLC borrower-
- has the borrower received a cash distribution from the LLC
- did the borrower guarantee any loans obtained by the LLC
S Corporation-
This is the legal entity that has a limited number of stockholders and elects not to be taxed as a regular corporation. The business gains and losses are passed to the stockholders.
This business entity has many similarities to the partnership. The stockholders are taxed at their individual tax rates for their share of ordinary income, capital gains, and other taxable elements.
The ordinary income is passed to the individual on the K-1 of the 1120S. The cash flow is evaluated very similarly to the corporation.
Corporation-
This kind of self-employment is a state-chartered legal entity that exists separately and distinctly from its owners. These owners are called stockholders or shareholders. The corporation is the most flexible form of business organization for purposes of obtaining capital or resources for operations.
The corporation can sue, be sued hold, covey, or receive property. They can enter into a contract under their own name and will not dissolve when the owner change.
Two types of Corporations exist: Publicly owned and privately owned.
Publicly owned are widely held corporations and closely held are privately owned. Why the latter?
More than 50% of the outstanding stock of a privately owned corporation is owned directly or indirectly by no more than five members. This type of corporation has little or possibly no access to public funds and must raise capital through institutional financing.
The stockholders are not usually responsible for the day-to-day operations of the business even though they have legal control of the corporation. There exists a board of directors and the distributions of the profits earned by the business are determined by this board. These profits normally flow down to the owners in the form of dividends.
The stockholders are not personally liable for the debts and the losses are limited to his/her individual investment in the corporation’s stock.
Some owners are paid a salary from the corporation and it is reported on the Form W-2. Like any other borrower, the underwriter is evaluating this income by analyzing the past 2 years’ W-2 earnings. Year-to-date pay stub earnings are included.
The corporation’s returns are evaluated to see if the company is stable. Thus the past 2 years will indicate either a profit or loss for the corporation and the distributions to its members. The corporation will pay taxes on its net income.
Keeping accurate records of your income and expenses…is crucial for The Ultimate Guide to Self-Employment Income Analysis…
One of the most important steps in analyzing your self-employed income is keeping accurate records of your income and expenses. This includes tracking all sources of income, such as payments from clients or sales of products, as well as any expenses related to your business, such as supplies, equipment, and office space.
By keeping detailed records, you can accurately calculate your net income and identify areas where you may be able to reduce expenses or increase revenue. Consider using accounting software or hiring a professional accountant to help you keep track of your finances. **Most self-employed individuals usually hire a tax accountant to help them with their tax forms and filings with includes -1040s plus self-employed tax forms.
In addition to tracking your income and expenses, it’s important to regularly review and analyze your financial statements. This can help you identify trends in your business, such as seasonal fluctuations in revenue or areas where expenses are consistently high. By understanding your financial situation, you can make informed decisions about pricing, marketing, and other aspects of your business.
It’s also important to set aside money for taxes and other expenses, such as insurance and retirement savings. By taking a proactive approach to managing your self-employed income, you can ensure long-term success and stability for your business.
Calculate your net income and adjust for taxes…
Once you have a clear understanding of your total income and expenses, it’s important to calculate your net income. This is the amount of money you have left over after deducting all of your business expenses from your total income.
It’s important to remember that as a self-employed individual, you are responsible for paying both income tax and self-employment tax on your net income. Be sure to set aside a portion of your income to cover these taxes and adjust your budget accordingly. Consider consulting with a tax professional to ensure you are accurately calculating and paying your taxes.
Consider the stability and consistency of your income…
When analyzing your self-employed income, it’s important to consider the stability and consistency of your earnings and the company. The lender will automatically look at the aforementioned.
Unlike traditional employees who receive a regular paycheck, self-employed individuals often experience fluctuations in their income.
This can be due to a variety of factors such as seasonal changes, market trends, or changes in client demand. It’s important to take these fluctuations into account when creating a budget and planning for the future.
Consider setting aside a portion of your income during high-earning periods to help cover expenses during slower periods. Additionally, consider diversifying your income streams to help mitigate the impact of fluctuations in any one area of your business.
Self Employment f1040sse Schedule SE
EndNote:
In The Guide to Self-Employed Income Analysis, we urge you to follow these simple rules…Use your income analysis to make informed financial decisions
By analyzing your self-employed income, you can make informed financial decisions that will help you achieve your goals. This includes creating a budget, setting financial targets, and planning for the future.
Understanding what your bottom line income actually is can also help you identify areas where you can cut costs or increase revenue. For example, if you notice that a particular service or product is consistently generating a high income, you may want to focus more on that area of your business.
On the other hand, if you notice that a particular service or product is consistently generating low income, you may want to consider phasing it out or finding ways to improve its profitability.
Ultimately, the more you understand your self-employed income, the better equipped you will be to make smart financial decisions that will help you achieve your goals.
*Note: In mortgage lending specifically- most lenders, banks, mortgage brokers, etc. use the GSEs (Fannie Mae, Freddie Mac) for underwriting purposes. They use their automated underwriting system for evaluation. If your credit scores are excellent, you have sufficient assets for closing costs and downpayment…you may only need to submit 2-yrs of your 1040s without all of the other self-employed forms. **There are exceptions to many rules usually when you have excellent credit.
