5304.1: Stable monthly income and documentation requirements for self-employed Borrowers (09/19/18)

This chapter provides the requirements to determine the appropriate qualifying income for a self-employed Borrower.

Self-employed Borrower definition and verification of ownership interest percentage (Section 5304.1(a))
Loan Product Advisor® (Section 5304.1(b))
Self-employment history requirements (Section 5304.1(c))
Business and income analysis (Section 5304.1(d))
Self-employment income not used for qualification (Section 5304.1(e))
Business assets used for closing (Section 5304.1(f))
Verification of the current existence of the business (Section 5304.1(g))
Documentation requirements (Section 5304.1(h))

Refer to Section 5301.1 for additional information with respect to income stability and continuance.

(a) Self-employed Borrower definition and verification of ownership interest percentage

A Borrower who has an ownership interest of 25% or more in a business is considered to be self-employed. The business may be a sole proprietorship, a Partnership (general or limited), an S corporation or a corporation.The business structure determines the reporting method of the business and self-employment income to the Internal Revenue Service (IRS). The federal income tax returns for the business usually document the percentage of ownership interest in the business.The following chart contains requirements and guidance for determining self-employment and verifying the Borrower's business ownership percentage:

Business structure	Self-employment verification of ownership interest percentage
Partnerships, S Corporations and Corporations	The ownership interest percentage must be verified by a review of the federal income tax returns for the business, including the IRS Schedule K-1(s) or IRS Form 1125-E, Compensation of Officers. If these documents do not provide this information, the ownership interest percentage must be verified with a letter from the accountant for the business or similar documents
Sole Proprietorships	Sole proprietorships are unincorporated businesses. A sole proprietor owns 100% of the business and reports the income and expenses from that business on Schedule C of the federal individual income tax return. There is no associated federal business tax return.

(b) Loan Product Advisor

The Seller must indicate to Loan Product Advisor that a Borrower is self-employed when the Borrower meets Freddie Mac's definition of self-employed as stated in Section 5304.1(a). This is required in all cases where the self-employment income and/or loss is used to determine the Borrower's stable monthly income for qualifying.

(c) Self-employment history requirements

The following chart contains requirements and guidance pertaining to self-employment history:

Self-employment history
Subject	Requirements and guidance
Length of history requirement	A two-year history of current self-employment is required in most instances to ensure that income is stable. The self-employment must be documented on Form 65, Uniform Residential Loan Application and verified in accordance with this chapter.
Self-employment less than two years	In certain instances, a Borrower may not have a current two-year history of self-employment; however, the income and employment may still be considered stable if the Seller provides a written analysis justifying the determination of stability, and sufficient supporting documentation is obtained. When making this determination, the Seller must take into consideration the overall layering of risk, including the Borrower's demonstrated ability to repay obligations. When the Borrower has been self-employed for less than two years, prior to considering the income for qualifying purposes, at a minimum the Seller must: Document that the Borrower has a two-year history of receipt of income at the same or greater level in the same or similar occupation Consider and evaluate the Borrower's experience in the business Consider and evaluate the acceptance of the company's service or products in the marketplace Analysis of current business activity through a review of the year-to date (YTD) financial statement and/or the most recent three months of business bank statements may provide support to this evaluation.
Minimum history of receipt of income	The Borrower's federal income tax returns must reflect at least one year of self-employment income
Geographical relocation	If the Borrower is relocating to a different geographic area, prior to considering the income for qualifying purposes, at a minimum the Seller must: Consider and evaluate the acceptance of the company's service or products in the marketplace. Additional information, such as market studies or relevant industry research, may support this evaluation. Provide a written analysis justifying the Borrower's income will continue at the same level in the new location

(d) Business and income analysis

The following chart contains requirements and guidance pertaining to business and income analysis:

Analysis
Topic	Requirements and guidance
Business and income analysis	Business review and analysis: The Seller's analysis of the business must support that the business has sufficient liquidity and is financially capable of producing stable monthly income for the Borrower. The analysis must include a review of the business tax returns The Seller's review must include, at a minimum, an analysis of gross receipts or sales, cost of goods sold and gross profits. All should be typical for the type of business and reflect consistent year over year trends. In addition, the business expenses should be reasonable for the type of business activity and level of business income. Business tenure should be considered. The Seller may determine that review and analysis of the business financial statements, business asset statements, and in the case of Partnerships and S corporations, an analysis of the historical cash distributions, is necessary to establish the financial and liquidity standing of the business. In addition, the Seller may calculate and consider the liquidity ratios of the business using generally accepted accounting practices when analyzing the liquidity of the business. Use of business income reported on the Borrower's federal individual income tax returns For sole proprietorships, stable monthly income must be based on the income reported on Schedule C of the Borrower's federal individual income tax returns For Partnerships and S corporations, stable monthly income may be based on the Borrower's proportionate share of income (e.g., ordinary income, guaranteed payments) carried from the Form 1065 or 1120 S, through the Schedule K-1 and onto the Borrower's federal individual income tax returns. Although cash distributions reported on the Schedule K-1 may not be used as qualifying income, they may be used to establish business liquidity and access to business funds, provided they are reasonably consistent with the ordinary income. For S corporations and corporations, stable monthly income may be based on the income reported on the Borrower's W-2 from the business. The corporate tax returns and Form 1125-E if applicable, must be reviewed for confirmation of the Borrower's W-2 income from the business. Use of business income not reported on the Borrower's federal individual income tax returns Income reported on the business tax returns but not on the personal tax returns may be considered as stable monthly income, provided the Seller's analysis confirms that based on the financial strength of the business, the use of these funds as personal income would not have a detrimental impact on the business Access to business income Documentation is not required to verify access to business income for the following: Sole proprietorships Ordinary income, net rental real estate income, other net rental income and guaranteed payments received from partnerships and S corporations W-2 income received from S corporations and corporations, Corporations, if the Borrower holds 100% ownership interest If business income not reported on the Borrower's federal individual income tax returns is being used to qualify and none of the categories above apply, then the Seller must verify that the Borrower's legal right to the business income that is used as stable monthly income is not encumbered, restricted or prevented by the corporate resolution, partnership agreement, or other comparable document. Income calculation The Seller's calculation of a self-employed Borrower's average monthly income must be based on a review of the Borrower's complete federal individual income tax returns (Form 1040) including W-2's and Schedule K-1's (if applicable) and the Borrower's complete federal income tax returns for the business (Forms 1120, 1120 S and 1065), when applicable. The Seller must analyze the tax returns and document the calculation of the Borrower's self-employed income on Form 91, Income Calculations, or a similar alternative form. Income fluctuation As part of the analysis, the Seller must consider whether the Borrower's self-employed income has increased or decreased over the previous two years when the Seller's analysis includes a review of documentation covering a history greater than one year If the analysis reflects that the Borrower's income has significantly increased or decreased, the Seller must provide sufficient documentation and justification to support the determination that the income used to qualify the Borrower is stable and likely to continue for the next three years It may be necessary to obtain additional years' tax returns when the Borrower's self-employment income fluctuates in order to determine the stability of the income
Business financial statements	Business financial statements typically consist of a profit and loss statement and a balance sheet for the business that cover a specified period of time (e.g., YTD, annual). Financial statements for the business may be prepared by multiple parties, including but not limited to, the Certified Public Accountant (CPA), accountant or tax preparer that prepares the tax returns for the business, or the Borrower Financial statements may not be used for the calculation of stable monthly income (unless audited); however, they may provide additional support for the Seller's business and income analysis Financial statements for the business may be used to assist in evaluating and determining various components of self-employment analysis, including, but not limited to, business liquidity, income stability when tax returns are on extension, evaluating a newer business and the impact of business fund withdrawals
Income analysis – adjustments (examples)	The following list includes common examples of items that may be considered for inclusion in income when performing the self-employed income calculations on Form 91, Income Calculations, or a similar alternative form.
	Non-cash deductions Non-cash items such as depreciation, depletion and amortization
	Non-recurring losses Documented nonrecurring losses, such as casualty losses and loss carry-overs from previous tax years
	Mortgages and notes payable in less than one year The Seller must analyze the terms of the Mortgages and notes payable in less than one year and determine whether the income should be reduced by the debt when performing the income analysis The analysis must include factors such as whether the business has sufficient liquidity to pay off the debt without a negative impact to the business, if the business type is indicative of debt that would continually roll over, and/or if the debt is a line of credit that is consistently renewable. If these factors are present, the income does not need to be reduced by the debt when performing the income analysis.
Borrower debt paid by business	Refer to Section 5401.2(b)(iv) for requirements for self-employed Borrower's debt paid by the Borrower's business.
IRS Form 8825, Rental Real Estate Income and Expenses of a Partnership or an S Corporation	Rental real estate income and expenses reported on Form 8825 All rental real estate income and expenses reported on IRS Form 8825 for partnerships and S corporations are to be treated as self-employment income, regardless of whether or not the Borrower is personally obligated on the Note. The requirements of Section 5401.2(b)(iv) are not applicable. Refer to Form 91 for the appropriate treatment and calculation of the Borrower's proportionate share of the net rental real estate income or loss.

(e) Self-employment income not used for qualification

The following chart contains requirements and guidance pertaining to self-employment income not used for qualification:

Self-employment income not used for qualification
Subject	Requirements and guidance
Self-employment disclosed on Form 65, Uniform Residential Loan Application (or other documentation) but not used to qualify	The Seller is not required to obtain any additional documentation or evaluate the income or loss from the self-employment for each Borrower on the Mortgage who: Has a primary source of income, other than self-employment, used for qualifying for the Mortgage (e.g., salaried income from primary employment), and Is self-employed and self-employment income is a secondary source of income For each Borrower on the Mortgage who is self-employed and does not have another source of income that is used in qualifying for the Mortgage, the following requirements apply: The Seller must obtain pages 1 and 2 of the Borrower's federal individual income tax returns, and the applicable schedules (e.g., Schedule C, Schedule E), to determine if there is a business loss that may have an impact on the stable monthly income. Refer to Section 5302.4(b) for information about using IRS tax transcripts to meet certain portions of this requirement. If a business loss is reported and the Borrower qualifies with the loss, then the Seller is not required to obtain any additional documentation relating to the business loss If a business loss is reported and the Borrower does not qualify with the loss, then the Seller must perform a business and income analysis to determine whether depreciation adjustments or other factors such as business closure or evidence of a one-time non-recurring event justify a reduction of the reported loss when calculating the stable monthly income. The Seller must obtain additional documentation needed in order to fully evaluate the loss and support the analysis (e.g., business tax returns (final or otherwise), evidence of a one-time non-recurring event). If the tax returns or other documentation in the Mortgage file (e.g., IRS tax transcripts, additional Schedule K-1's) reflect positive income from self-employment but that income is not used to qualify, additional documentation (e.g., complete business or federal individual income tax return(s)) is not required

(f) Business assets used for closing

The following chart contains requirements and guidance pertaining to business assets used for closing:

Subject

Requirements and guidance

Business assets used for closing

Withdrawals of assets from the business may have a negative impact on the ability of the business to continue operating. When business assets are being used for the Down Payment, Closing Costs and/or reserves, the Seller must determine that the withdrawal of the funds will not have a detrimental effect on the business. In addition to a review and analysis of the personal and business tax returns, the Seller may review and analyze the current financial statement and/or the last three months of the business bank statements to confirm the deposits, withdrawals and balances are supportive of a viable business and are aligned with the level and type of income and expenses reported on the business tax returns.
The factors contributing to the determination that the withdrawal will not negatively impact the business must be included on the Seller's written analysis of the income source and amount

The business assets must be verified in accordance with the documentation requirements in Sections 5102.3, 5102.4 and 5501.3.

(g) Verification of current existence of the business

The following chart contains requirements and guidance pertaining to verification of current existence of the business:

Topic	Requirements and guidance
Verification of current existence of business	Verification of the current existence of the business is required when positive income from the business is used as stable monthly income
Acceptable third party sources	Acceptable third party sources include, but are not limited to: Regulatory agency Phone directory Internet source (e.g., Better Business Bureau) Directory assistance Applicable licensing bureau Verification of current existence of the business obtained verbally from an acceptable third party source must be documented and include all of the following: Name and address of the business Name of individual and entity contacted to obtain the verification Date information verified Name and title of the individual who completed the verification for the Seller
Alternative sources	The Seller may consider alternative sources if the above are not available, such as: Preparer of the tax returns for the business (e.g., accountant), provided the preparer has an arm's length relationship with the Borrower At least one months' business bank statement that supports the current existence of the business and the level and type of income and expenses reported on the business tax returns
Date requirements	The verification must be completed prior to the Delivery Date, but no more than 120 days prior to the Note Date

(h) Documentation requirements

The Seller must establish and calculate the stable monthly income using at least the following required documentation. Additional documentation may be needed to support income stability, as described within this chapter.

Form 91, Income Calculations, or a similar alternative form
Verification of the current existence of the business as described in Section 5304.1(g)
Federal income tax returns, as required in the chart below, including all applicable schedules and forms must reflect at least 12 months of self-employed income
Verification of how long the business has been in existence:
- For partnerships, S corporations and corporations, the federal income tax return(s) for the business must indicate the number of years that the business has been in existence
- For sole proprietorships, the federal individual income tax return(s) and any other documentation or information received must not contradict the number of years that the business has been in existence as documented on Form 65, Uniform Residential Loan Application

Business structure	Streamlined Accept and Standard Documentation Levels
Business structure	Business in existence greater than or equal to five years	Business in existence less than five years
Sole Proprietorship	Complete signed federal individual (Form 1040) income tax return for the most recent year.	Complete signed federal individual (Form 1040) income tax returns for the most recent two years.
Partnership	Complete signed federal individual and Partnership (Form 1065) income tax returns, including the Schedule K-1(s) for the most recent year.	Complete signed federal individual and Partnership (Form 1065) income tax returns, including the Schedule K-1(s) for the most recent two years.
S Corporation	Complete signed federal individual and S corporation (Form 1120S) income tax returns, including the Schedule K-1(s), Form 1125-E and W-2(s) if applicable, for the most recent year.	Complete signed federal individual and S corporation (Form 1120S) income tax returns, including the Schedule K-1(s), Form 1125-E and W-2(s) if applicable, for the most recent two years.
Corporation	Complete signed federal individual and Corporation (Form 1120) income tax returns, including Form 1125-E and W-2(s) as applicable, for the most recent year.	Complete signed federal individual and Corporation (Form 1120) income tax returns, including Form 1125-E and W-2(s) as applicable, for the most recent two years.