Ever wonder why the IRS tax code is currently at 74,608 pages of information? (and yes, this is a rhetorical question). I am convinced it is a ploy to drive us nuts around tax time. I mean what did we do to the IRS to mess with us so much!
So here is a twist, you review a borrower’s application, it seems that they are employed by one company, but their paycheck seems a little off. You put on your good glasses….
Hmmm, year to date income…check….
Name of employer…check…
Wait!! Where are the state and federal taxes?
My friend you may have just come across a statutory employee!
Definition of a statutory employee
Quoted from investopida.com
A statutory employee is an independent contractor that is treated as an employee for tax withholding purposes if they meet certain conditions. Employers are not permitted to withhold taxes for most independent contractors, but statutory employees differ in that they exist in a place between employee and independent contractor. This class of employee may deduct work-related expenses on Schedule C instead of Schedule A. Statutory employees are usually salespeople or other employees who work on commission but may also individuals who provide services while using a company’s tools or resources. “Statutory” refers to Internal Revenue Service (IRS) classification of such workers as subject to tax withholding by statute under its common-law rules.
Calculating a statutory employee’s income
The best way to handle this borrower is to list them as employed and report the income as commission. This may seem counter intuitive at first. The borrower uses a Schedule C to report final income, but they are not fully self-employed. By using commission as the income type you are giving the (LPA/DU/GUS) the correct input that the income is all variable and not guaranteed. The AUS should require a two-year look at the income which would be a proper evaluation of the risk.
- Review the Schedule C for both years. Calculate the income the same method you do for a standard schedule C borrower (i.e. take line 31 + line 30,etc., etc.)
- If the income is trending up, use a 24-month average. However, if the income is trending down, use a twelve-month average. If the income is trending down severely then you may not be able to use the income at all. It is up to your company to decide what is severely. I suggest 20%.
- Confirm the YTD is in line with your trending analysis. This is where a little extra math is needed. The way I would do this is as follows:
- Confirm percentage of expenses the borrower write’s off each year compared to the gross income received on line 1 of the Schedule C. For example, if line 1 said $100,000 and line 31 said $50,000 I would conclude that the borrower loses 50% of every dollar earned to expense.
- Get the borrowers YTD paystub and take the gross amount earned YTD then divide by the number of months that have elapsed based on the pay period end date. Then multiply that amount times the average expense amount in the previous year. For example, if the June 30th Paystub showed $50,000 gross I would divide by six months and get $8333.33 per month then remove the 50% of expenses to confirm the borrower’s final gross income is $4,166.67.
Keep in mind in almost all cases I would not use the YTD income. Generally use the one or two-year average from the tax returns. But that is not to say that you could not use that number if circumstances warranted it.
Hopefully this did not add to the confusion from the IRS tax code, but instead laid out a clear method to handle the Statutory Employee.
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