How to underwrite a statutory employee?

One of the more unusual income types that you will run across is a statutory employee.  You can spot them right away when you are looking at their pay stubs.  They will have the normal SSA, Medicare, and health insurance deductions, but will have no deductions for federal, state, or local taxes.  Generally they will have filed schedule C tax forms.

A first glance you might think these borrowers are self-employed because of the schedule C form.  When you look closer you will see their w-2 income will match the “gross sales” line on schedule C (another thing that seems odd compared to most income types).  To make it even more difficult the schedule C will look pretty much identical to any other sole proprietor or independent contractor.

But don’t fall into this trap, they are in fact employees and will require all the same documentation an employed borrower.  They should be treated very similar to commissioned employees!

 

How to underwrite a statutory employee

Let’s dive into the who, what, why, and how of underwriting a statutory employee.

What is a statutory employee?

Wikipedia gives a really good underwriting overview of this employment type:

 A statutory employee is an independent contractor under IRS common law that is treated as an employee, by statute, for tax withholdings. For a standard independent contractor, an employer cannot withhold taxes, as this would change the independent contractor relationship into an employer-employee relationship. Statutory employees are also permitted to deduct work-related expenses on Schedule C instead of Schedule A in the United States tax system. As a result, they are allowed a greater tax deduction for business expenses than standard employees, as Schedule C expenses are not subject to the 2% adjusted gross income threshold as seen with Schedule A.

 

Examples of borrowers who will be statutory employees

• A life insurance agent whose core business is life insurance and annuity for one company.
• Someone who works from home on materials an employer supplies, that must be returned and for which the employer gives work specifications.
• A traveling salesperson who turns in orders from wholesalers, retailers, contractors, hotels, or restaurants, either for resale or business use. Work performed must be the principal business activity of the employee

 

How to calculate income for the statutory employee

Step 1 – Start with the correct income

The good news here is that working with a statutory employee basically uses the same methods as a commissioned borrower.  Income is determined by gross income minus unreimbursed business expenses, with a slight twist.  The twist is using line 31 of the schedule C with the normal “add back’s and deductions”.  For this you would add back depreciation and subtract the M/E expenses as the gross income.  In other words, normal commissioned employees, you start with W-2 minus URBE’s.  For statutory employees, you ignore the W-2 income and use line 31 from schedule C.

Before we move any further my recommendation is to follow your companies approved method of commissioned income borrower.  But if you need advice on a new process or method here are my suggestions on how to best determine this borrower’s income.

Step 2 calculate the trending analysis

Calculate the average monthly income is per year to confirm stable income trend. Divide the Schedule C gross income by 12 months to get the average monthly income.  Calculate this for the last two tax years.

For the current year you can’t just take the paystub income and divide by the number of months. This will not work because the borrower write’s off a good portion of his/her income.  To be accurate determine the percentage of write off’s the borrower has done in 2016 and 2015 and apply this same percentage to the YTD gross.  Once you have deducted the anticipated expense then divide the paystub by the number of months in the current year.

Review the trend for all three years according to your company guidelines on trending analysis.  Once you have this trending income confirmed as stable and acceptable, you can now move to step three!

Step 3 Determine the final income

These two methods have been the most popular and in my experience the most accurate.  Honestly, I don’t think one is better than the other, so work with your risk manager to see which method will fit your companies risk appetite the best.  Keep in mind these incomes are basically following the same thought process as commissioned income.  Before you start averaging the numbers below, you should have already passed the trending analysis in step two.
 

Method 1 (more conventional based thought process)

1. Gather the annual income values for YTD and the two tax years as determined in Step One
2. Calculate average of YTD + most recent tax year
3. Calculate average of YTD + most recent tax year + previous tax year
4. Select the average that is supported by the trending analysis

 

Method 2 (more FHA based thought process)

1. Calculate the average of the last two year tax returns to determine the effective income
2. Check that the YTD income has not decreased by more than 20% from the effective income in the prior step.
3. If the YTD income has decreased by more than 20% from the prior year, use the lower YTD income, otherwise use the average of the last two tax years.

 

So now you know how to handle the income for a statutory employee, I want to throw in a quick plug to use IncomeXpert to quickly and accurately complete all the trending analysis outlined in the steps above.  IncomeXpert is designed and built to handle all income types outlined in FNMA/FHLMC/FHA guidelines.