Self-Employed Applicant Qualification

Generally, a borrower is considered self-employed if they have a 25 percent or greater ownership interest in a business. This definition applies regardless of the business structure, which may include sole proprietorships, partnerships, limited liability companies (LLCs), S corporations, or corporations. Even if a borrower is a W-2 employee of a company they own, lenders must evaluate them as self-employed if their ownership stake meets this threshold. Conversely, if a borrower holds less than a 25 percent interest, their income is typically treated as employed income, though Schedule K-1s or other documentation may still be reviewed to ensure the income is stable and distributed.

Lenders typically require a two-year history of self-employment to demonstrate income stability and the likelihood of continuance. However, a borrower with less than two years of history—usually between 12 and 24 months—may still qualify if they can document prior successful employment in the same or a related occupation. In these cases, the lender must document that the borrower has a combined two-year history of earnings and that the new business provides sufficient income. The VA similarly requires two years but allows for less than that with extensive justification and specialized training.

While two years of tax returns are standard, agencies like Fannie Mae and Freddie Mac permit the submission of only one year of personal and business federal tax returns under specific conditions. Typically, this exception applies if the borrower has been self-employed in the same business for at least five years and the business is financially strong. The borrower’s most recent tax return must show that the income is stable or increasing compared to the prior year. This streamlined documentation reduces the paperwork burden for established business owners with consistent earnings histories.

A sole proprietorship is an unincorporated business individually owned by the borrower, where the owner accepts personal liability. Income is reported on IRS Form 1040, Schedule C. Lenders analyze the Schedule C to determine the net profit or loss. To calculate qualifying income, lenders may add back certain non-cash expenses claimed on the tax return, such as depreciation, depletion, and casualty losses, to the net profit. Conversely, non-recurring income reported on Schedule C that is not expected to continue must be deducted from the borrower’s cash flow analysis.

For borrowers owning 25 percent or more of a partnership or S corporation, lenders must analyze the business’s financial strength using IRS Form 1065 or 1120S and the associated Schedule K-1s. The borrower’s proportionate share of income or loss is considered. Importantly, ordinary income reported on a K-1 can generally only be used for qualifying if the lender documents that the business has adequate liquidity to support the withdrawal of those earnings. If the borrower has a history of receiving stable cash distributions consistent with the reported income, further proof of liquidity may not be required.

Yes, business assets are an acceptable source of funds for down payments, closing costs, and financial reserves, provided the borrower is an owner of the account. However, the lender must perform a business cash flow analysis to ensure that withdrawing these funds will not have a negative impact on the business’s ability to operate. If the withdrawal would jeopardize the business’s financial standing, the assets cannot be used. This assessment often requires reviewing recent business bank statements or a current balance sheet to confirm the business has sufficient liquidity.

Stability of income is critical. If a business shows a steady or significant decline in earnings over the period analyzed, the lender must investigate the cause to determine if the trend will reverse or continue. Generally, if the income has declined by more than 20 percent, it is not considered stable and cannot be used for qualifying unless the lender documents that the business income has stabilized or recovered. In cases of severe decline, the lender may be required to use the lower, current income level rather than an average of previous years.

Lenders must verify the current existence of the business closer to the closing date, typically within 120 calendar days prior to the note date. Acceptable verification methods include obtaining a statement from a third party such as a CPA, regulatory agency, or applicable licensing bureau. Alternatively, the lender may verify the business via a phone listing, internet search, or directory assistance. This step ensures that the business generating the qualifying income is still operational and capable of providing the income used for loan approval.

To ensure accuracy in calculating qualifying income, lenders often use specific forms like Fannie Mae’s Cash Flow Analysis (Form 1084) or Freddie Mac’s Income Analysis (Form 91). Additionally, automated tools such as the Income Calculator or Loan Product Advisor’s automated income assessment (AIM) can be used. These tools help analyze tax returns and Schedule K-1s to determine stable monthly income. Using these approved technology tools can sometimes offer lenders relief from representations and warranties regarding the accuracy of the income calculation, provided the data submitted is accurate and complete.

If a borrower changes their business structure (e.g., converting from a sole proprietorship to an S corporation), the lender must determine if it is effectively the same business. To count the history from the previous structure, the borrower’s ownership percentage must typically remain similar, and there should be no fundamental change in the business’s products, services, or location. The lender must also ensure the change has not negatively impacted business revenue or expenses. If these conditions are met, the current and prior business structures can be considered a single continuous operation for the purpose of calculating self-employment history.