Make Sure Self-Employed Resident's Tax Returns Are Accurate, Complete

In most cases, you need to verify household income with third-party employers because household members usually earn their income through jobs. But you may encounter a household member who works for herself. In this situation, you must follow the HUD Handbook’s requirements for verifying self-employment income. HUD’s preferred method of verifying self-employment income is getting a copy of the household member’s federal tax return, including supporting schedules [Handbook 4350.3, App. 3].

But simply asking household members to give you copies of their returns could lead to problems. It’s not always easy to tell whether a return is complete; key schedules or other pages could be missing. Also, there’s a risk that the household member will doctor her tax return to lower her income and increase the chances that her household will be considered eligible to occupy a low-income unit at your site.

Fortunately, you can take steps to help ensure that the tax returns you get to verify self-employment income are accurate and complete. Here are two steps that will help you create accurate household certifications and avoid noncompliance.

Acceptable Forms of Verification

Appendix 3 of HUD Handbook 4350.3 provides a list of forms that are acceptable to document self-employment:

Form 1040 with Schedule C, E, or F. This is a tax return. According to the IRS’ Guide for Completing Form 8823, Low-Income Housing Credit Agencies Report of Noncompliance or Building Disposition, under the section entitled, “Income from a Business,” a tax return must be filed for all self-employed individuals who operate sole-proprietorship businesses or otherwise report income on Schedule C, regardless of whether the taxpayer is reporting a profit or loss.

Schedule C is Profit or Loss From Business Form used for sole proprietorships, Schedule E is the Supplemental Income and Loss Form used for rental real estate, royalties, partnerships, S corporations, estates, and Real Estate Mortgage Investment Conduits. Schedule F is the Profit or Loss From Farming Form.

Financial statements of the business. These can either be audited or unaudited. You must obtain an accountant’s calculation of straight-line depreciation expense if accelerated depreciation was used on the tax return or financials.

Loan application. The application must be comprised of income that’s derived from business during the preceding 12-month period.

For rental properties: Copies of rent checks, full copy of the lease, receipts for expenses, or the previously mentioned Schedule E.

Calculating Self-Employment Income

Unlike other income sources where gross income is counted, the net income from the operation of a business, profession, or sole proprietorship businesses is counted for self-employment instead. Net income is gross income less business expenses, interest on loans, and depreciation computed on a straight-line basis. Salaries paid to the applicant or other household members from the business must also be identified and included in income. In addition, cash and assets withdrawn by family members must be included in income except when the withdrawal is a reimbursement of cash or assets invested in the business.

Business expenses don’t include principal payments on loans, interest on loans for business expansion or capital improvements, or other expenses for business expansion or outlays for capital improvements.

If the net income from a business is negative, it must be counted as zero income. A negative amount cannot be used to offset other family income. For example, a married couple applies to your tax credit site. The husband operates a sole proprietorship business; the net income from the business after expenses last year was -$3,500. The wife earns $27,000 each year as an employee, as shown on the W-2 from her employer. The household’s income is $27,000. The $3,500 loss generated by the husband’s business cannot be used to offset the wife’s wages.

In most cases, a business owner will have a lot of assets for the business. Any assets that are for the business are not included as assets. If the applicant’s business is real estate and they own properties, then just count any income as business income and do not count the properties as assets. If the applicant is just renting out his house rather than selling it then you would count the income from the rental and you would also count the real estate as an asset.

Step #1: Get Affidavit from Household Member

To deter fraud, ask each household member who earns income through her own business to sign a self-employment income affidavit. Your state housing agency may require you to use its own affidavit. If not, we’ve put together a Model Form: Deter Fraud with Self-Employment Income Affidavit, which you can use with households at your site. Using our affidavit will show your agency that you took the extra step to verify eligibility and ensure compliance with the tax credit program’s certification requirement. Our affidavit covers the following points:

Identifies household member. The affidavit identifies the household member by name, Social Security number, unit, and building identification number (BIN).

References attached tax returns. The affidavit says that the household member is attaching copies of all tax returns needed to verify her self-employment income, and it asks her to identify these returns.

Certifies accuracy of returns. The affidavit has the household member certify that the attached copies of the tax returns are accurate and complete. The household member must also certify that any returns she didn’t file with the IRS weren’t required under tax laws.

Warns household member against giving false or incomplete information. If you later discover that a household member misrepresented her income when completing the affidavit, it means that your certification was incorrect and the household might not have been eligible to occupy a low-income unit at your site. So it’s important to warn households against giving you false or incomplete information, and remind them that not acting truthfully may require you to evict them.

Step #2: Request Transcript from IRS

To verify that the tax return you get from a household member is a “true and accurate” copy of the return filed with the IRS, request an official transcript of the return from the IRS. The transcript details the information reported on a taxpayer’s most recent tax returns.

You can’t request a copy of the return from the IRS yourself; you must have the household member make the request for you. To do this, have the household member fill out and submit IRS Form 4506. This simple, one-page form asks the member to complete basic information about herself and the tax returns for which you need a transcript. For example, if you need a household member’s Form 1040 from last year and her Form 1040A from the previous year, the household member should specify these on the form (lines 6 and 7). Normally, the IRS mails transcripts to the household member who requests them, but you can tell the household member to direct the IRS to mail the transcript directly to you at no additional charge (line 5).

To get a copy of Form 4506, visit www.irs.gov. Type “4506” in the search box, select “Forms and Publications” from the pull-down menu, and hit “Go.” You can then download the PDF file. Print it for use with your households. The current fee for transcript requests is $50 per return, payable by check or money order. You may request up to eight transcripts per form. Your site should have a policy on who pays for this type of incidental fee—the owner or the household member. If your site also gets assistance through HUD, then the owner must pay this fee.