Self-employed borrowers

A. Definition/Risk/Stability

Definition

A Borrower is considered self-employed when his/her income is derived from a business in which she maintains a majority ownership interest or can otherwise exercise control over the business activities and greater than 50% of his/her income is derived from this business. AmMAC considers a 25% or greater ownership interest in the business as sufficient to exercise control, therefore requiring underwriting as a self-employed borrower.

Example - Partnerships with each of five general partners owning 20%. The Borrower is considered self- employed if this 20% ownership is the major source of income.

Increased risk

Self-employed Borrowers present a greater credit risk than salaried Borrowers because their income is directly linked to the success of their business. The following additional risks are associated with self-employed Borrowers:

• Difficulty in verifying actual income/cash flow
• Cash flow may not be regular, as it is affected by marketplace fluctuations
• Borrower may be liable for business debts
• Business may suffer from inadequate control or dissension among partners

Because of the increased risk associated with self-employed borrowers, AmMAC will not make loans to borrowers with more than three (3) self-employed businesses (all borrowers on the loan collectively). This includes all Schedule C, S-Corp, Partnership, and/or Corporation held businesses. It also includes properties held in LLCs.

 Two Year History

Income from self-employment may be considered stable if the Borrower has been self-employed two or more years (3 years of tax returns are required to prove business was a going concern for > 2 years).

The income of a Borrower with less than a two-year history of self-employment is not allowed.

Elements of Stable, Usable Qualifying Income

• To be considered in the loan qualification analysis, any self-employed income proposed for use must be from the same company for at least the past 2 years. Given the high incidence of new business failures within the first two years of existence, self-employed income from a business less than 2 years old may not be considered—even if it is in the same line of work as another business previously owned by the borrower. Top of Form

 

Documentation

The following additional documentation is required if the business is a corporation, Subchapter S corporation, or partnership:

Business Income Tax Returns - Copies of signed federal business income tax returns for the last three years with all applicable schedules attached:

Corporation - IRS 1120

S Corporation - IRS Form 1120S and Schedule K-1

General Partnership - IRS Form 1065, and Schedule K-1

Limited Partnership - IRS Schedule K-1

If extensions have been filed on any business tax returns, that income cannot be used in qualifying the borrower.

B. Required Documents

All Self-employed Borrowers

The following documents are required for all self-employed Borrowers:

Tax Returns - All self-employed Borrowers are required to provide copies of signed individual (and business if appropriate) tax returns, including all applicable schedules, for the previous three years. AmMAC will not lend to self-employed borrower’s whose prior year tax return has been extended (unless they or a co-borrower have sufficient salary income to qualify exclusive of any self-employment income). Bank Statements – Business bank statements (or personal bank statements if used for the business as well) must be provided for any calendar/fiscal year when tax returns have not yet been filed (provided the tax deadline has not yet passed) OR if the most recent year’s tax returns have been filed AND 180 or more days have elapsed since the last calendar/fiscal year-end, then business bank statements must be provided for the period since the last calendar/fiscal year-end. Interim Financial Statements – A year-to-date cash basis Income/Expense Statement and Balance Sheet prepared by the business’ accountant or bookkeeper, are required for the period  since the last fiscal year end, regardless of how many days have elapsed.

Request for Tax Returns from IRS (Form 4506-T)

Each Borrower(s) must execute an IRS Form 4506-T for both Business and Personal returns, at time of loan application and at loan closing for all loans. IRS Form 4506-T authorizes AmMAC to request copies of the tax returns from the IRS as needed to fulfill quality control and audit requirements.

Verbal Verification of Employment

See Verbal VOE’s for verbal verification of employment requirements.

  

C. Tax Return Analysis

Tax returns are analyzed to develop an estimated cash flow and to determine the trend of business and other income. Information from our tax return analysis will also be supplemented by our evaluation of business bank statements and interim Profit and Loss statements, as indicated in these Underwriting Requirements.

D. Evaluating IRS Form 1040

Introduction

The starting point of AmMAC’s analysis of self-employed Borrowers’ income, is to develop an average monthly income by using at least two full years of the Borrower's tax returns. Income from the year-to-date profit and loss statement may be included in determining the average monthly income, if that income is in line with the previous year's earnings and substantiated via bank statements.

Averaging

Because self-employment income may change each year, an average better approximates the Borrower's long-term earning ability. However, an average is not automatically the most accurate choice to use, depending on whether the income trend is stable, inclining, or declining. See Declining Income Policy below for AmMAC rules around the appropriate income source to use in each of these scenarios.

Earnings Trend

Establish the Borrower's earnings trend. Annual earnings which are generally level or increasing are acceptable. Specific sections covering Self-Employed Borrowers and/or those with bonus, commission, overtime or tip income, cover how to treat declining income in those income types.

Schedule F Income

AmMAC does not lend on properties used to generate income—including farming income of any kind. Because Schedule F does not independently verify the address used to generate the farming income being claimed, AmMAC will not lend to borrowers whose tax returns reflect farming income on Schedule F.

E. Evaluating Corporate Tax Returns (IRS Form 1120)

Purpose of Review

The primary purpose for reviewing business tax returns is to analyze the financial strength of the business and to confirm that it will continue to generate the income the Borrower needs to qualify for the requested loan. When the business tax return indicates a viable company, the corporation need not be investigated any further. It is never permissible under AmMAC requirements, to allocate additional business income to the Borrower (regardless of ownership %), other than what they are paid in salary from the corporation and we have verified via our standard bank statement analysis.

If the 2 most recently filed corporate tax returns both reflect losses, the corporation will not be considered viable, and any of the Borrower’s salary income received from that corporation must be excluded from the qualifying income analysis. However, because the corporate structure insulates the borrower from personal liability, business losses from the corporation are also not allocated to the Borrower.

  

F. Evaluating S-Corporation Tax Returns (IRS Form 1120S)

Calculation

IRS Form 1040 - The gains or losses of an S Corporation are passed on to the shareholders who are then taxed at the tax rates for individuals. This income or loss is reflected on Schedule K-1 (IRS Form 1120S) and transferred to Schedule E of the individual tax return.

The primary source of income for an owner of an S Corporation comes from W-2 wages which are traced to the "Compensation of Officers" line of the IRS Form 1120S and reported on IRS Form 1040.

IRS Form 1120S - If the Borrower provides evidence of access to S Corporation funds, the Borrower's share of depreciation and depletion expenses can be added to income for qualifying.

This combined figure, however, must be reduced by the total obligations payable in less than one year (allocated by ownership percentage). This adjustment provides verification that the business will be able to meet its short-term obligations.

The Schedule K-1 (IRS Form 1120S) must be reviewed to determine the Borrower's percentage of ownership.

Top of Form

G. Evaluating Partnership tax Returns (IRS Form 1065)

All Partnerships

Both General and Limited Partnerships use the IRS Form 1065 federal income tax return. The gains or losses of a partnership are passed on to the partners who are then taxed at the tax rates for individuals. This income or loss is reflected on Schedule K-1 (IRS Form 1065) and transferred to Schedule E of the individual tax return.

Depreciation and depletion from the partnership tax returns can be proportionately (by ownership percentage) added back to the Borrower's income since these are non-cash expenses.

This combined figure, however, must be proportionately (by ownership percentage) reduced by the total obligations that are payable in less than one year. This adjustment provides verification that the business will be able to meet its short-term obligations.

The Schedule K-1 (IRS Form 1065) is used to determine the Borrower's percentage of ownership for proportional allocations of income, expenses and liabilities.Top of Form

H. Declining Income Policy – Self Employment

AmMAC will use the most recent data available between tax returns and business bank statements, to arrive at an estimation of the income from the business, as follows:

• Two most recent years tax returns, if filed (at least one year must be filed and verifiable via 4506-T or income cannot be counted to qualify).
• If the most recent year’s tax return has not yet been filed, the last 2 filed tax returns are required, plus 12 months bank statements covering the unfiled tax year PLUS a cash based Profit & Loss Statement and Balance sheet covering the same period and prepared by an accountant, may be submitted in lieu of that year’s tax return. (Note: This option is only available prior to the tax deadline for the most recent tax year—once that deadline is passed, the return must have been filed or the borrower will not be eligible for financing.). 4506-T results for the most recent year must still be retained in the loan file, indicating ‘No Transcript Available’, as proof that the current years taxes have not yet been filed.
• All business bank statements since the last filed tax return, if 180 or more days have elapsed since last fiscal year-end.
• Interim cash based Profit & Loss Statement and Balance Sheet, from an accountant from the last fiscal year end to present, regardless of the amount of time elapsed since the last fiscal year-end.
• Although the tax returns for the third year prior our application, do not need to be provided for income documentation purposes, we will always obtain a 4506-T for that year, in order to confirm that the business has been in existence at least 2 years. The results of this transcript may also be used to identify trends in net income.

The table below details the preferred sources of income documentation, depending on whether or not the tax filing deadline has passed.

Preferred Source	2 Years Prior to Loan Application (CY-2)	Year Prior to Loan Application (CY-1)	Year of AmMAC Loan Application (CY)	Notes
1st choice	Federal Tax Return	Federal Tax Return, unless tax deadline has not yet passed	Bank Statements & YTD P&L	Bank stmts. will be used to validate revenue from interim P&L. Tax returns will be used to validate expense %. Use the lower of Bank Stmts. or P&L net income when evaluating income trend.
2nd choice	n.a. - no alternate documentation source will be considered.	Business Bank Statements. Once tax deadline is passed, Business Bank Statements are not an option.	n.a. – no alternate documentation source will be considered	Bank stmts. will be used to determine revenue only. Expense % will be taken from tax returns.

Once the above data is compiled, the income to be used for qualifying the borrower will depend on the trend (increasing/stable/decreasing) per the following table. “CY-3” is considered the base year and the trend in income is based on the change each year moving from left to right in the columns of the table. The correct table to use depends on whether taxes for the most recent year have been filed or not. Because monthly income for self-employed borrowers can vary significantly, we do not weight the Interim P&L data in the Declining Income analysis until there is at least 180 days of history in the interim period:

Version where CY-1 taxes are not yet filed:

CY-3	CY-2	CY-1	CY-1 P&L	Decision
From Tax Return Data	From Tax Return Data	From Bank Statements & Balance Sheet*	From P&L and Balance Sheet*
		Use lower of P&L or Bank Statement Income
Base	Down	Up		Use CY-3 - CY-2 average
Base	Down	Down		Decline (declining income)
Base	Up	Down		If CY-1 is down compared to CY-3 then Decline, if CY-1 is still up compared to CY-3 then use CY-1.
Base	Up	Up  (by no more than % CY-2 is up over CY-3)		Use CY-2 – CY-1 average. If P&L increase exceeds CY-3 – CY-2 increase, can’t use P&L and have to use CY-3 – CY-2 tax returns only.

* Estimated income from bank statements and/or P&Ls, needs to have debt coming due within 1 year, removed from income for any Partnership, S-Corp or Corporation income. Schedule C income does not require this adjustment.

Version with both CY-1 and CY-2 taxes:

CY-3	CY-2	CY-1	CY YTD	CY YTD P&L	Decision
From Transcripts	From Tax Return Data	From Tax return Data	>= 6 Months from Bank Stmts & Balance Sheet*	>= 6 Months from P&L and Balance Sheet*
			Use lower of P&L or Bank Statement Income
Base	Down	Up	X		Use CY-2 – CY-1 average
Base	Down	Down	X		Decline (declining income)
Base	Up	Down	X		If CY-1 is down compared to CY-3 then Decline, if CY-1 is still up compared to CY-3 then use CY-1.
Base	Up	Up	X		Use CY-2 – CY-1 average
Base	Down	Up	Down		Use CY-2 – CY-1 average
Base	Down	Down	Down		Decline (declining income)
Base	Up	Up	Up		Use CY-2 – CY-1 average
Base	Up	Down	Up		Use CY-2 – CY-1 average
Base	Up	Down	Down		Decline (declining income)

* Estimated income from bank statements and/or P&Ls, needs to have debt coming due within 1 year, removed from income for any Partnership, S-Corp or Corporation income. Schedule C income does not require this adjustment.