How to Calculate and Verify Income from Self-Owned Businesses
When certifying or recertifying households, you may occasionally encounter a household member who earns income from a self-owned business. For example, a household member may own a small retail store or hair salon, be a computer consultant or house painter, or own and run a daycare center or landscaping business. Calculating and verifying the household’s income from a self-owned business can be hard. You need to know what to count as income from the business so you can accurately calculate the household’s rent. And you must verify the income even though the member doesn’t have a regular employer or government source to whom you can send a verification form.
HUD has special rules on calculating income from a household member’s business and verifying that income. Here’s what you need to know.
What Income to Count
HUD Handbook 4350.3, par. 5-6(H) spells out how to calculate the household’s income for the year when a household member has a self-owned business. Here’s what to include in household income and how to calculate it:
Salaries paid to adult household members. Count the amount each adult household member gets as a salary from the business [HUD Handbook 4350.3, par. 5-6(H)(1)]. Don’t confuse salaries with the income the household gets from the business; that needs to be treated separately. A salary paid to a household member is an expense for the business but part of the household’s income.
Example #1: A household member owns a hair salon. She rents space for the salon in the back of a retail store. Both the household member and her daughter (also a household member) work at the salon. The household member pays herself and her daughter a salary out of the salon’s gross revenues. Count their salaries as part of household income.
Cash or assets withdrawn by any household member. Count as income the amount of any cash or the value of any other assets that any household member withdraws from the business [HUD Handbook 4350.3, par. 5-6(H)(1)]. But don’t count as income cash or assets a household member withdraws as reimbursement for cash or assets previously invested in the business.
Example #2: The household member in Example #1 started the business by buying $1,000 worth of equipment and supplies with her own money. Five years later, she withdraws $1,500 from the business and puts it in her personal savings account. When determining the household’s income, don’t count $1,000 of the withdrawal as income because she had previously invested that amount to buy equipment and supplies. But count the remaining $500 of the withdrawal as income, since this was more than the household member had invested.
Business’s net income. Count as household income the net income that the business earns [HUD Handbook 4350.3, par. 5-6(H)]. Net income equals the business’s gross income (such as sales) minus:
- Business expenses (such as rent, salaries, cost of materials or supplies, utilities, insurance, and taxes). But business expenses don’t include the expenses or outlays for business expansion, capital improvements, or principal payments on loans for those purposes;
- Interest payments on loans (except for interest on loans for business expansion or capital improvements); and
- Depreciation computed on a straight-line basis. Depreciation is the write-off of an asset’s cost over time to account for its diminishing value because of use, obsolescence, deterioration, or wear and tear. Straight-line depreciation allocates an equal amount of the asset’s cost to the write-off each year for the useful life of the asset. That amount is then deducted each year as an expense from gross income.
Example #3: The household member’s hair salon in Example #1 has the following expenses: rent, salaries, hairdressing supplies, insurance, and utility costs. Three years ago, the household member took out a five-year loan to buy two hairdressing chairs to accommodate more clients. The chairs cost a total of $5,000 and have a useful life of 10 years. This year, she took out a short-term loan to cover cash shortfalls for buying supplies.
She can deduct the rent, salaries, hairdressing supplies, insurance, and utilities, as well as the principal and interest on the short-term loan from the business’s gross income. She can’t deduct the $5,000 cost of the chairs as a lump sum because that would probably be considered an outlay for business expansion. And she can’t deduct the principal payments and interest on the long-term loan she took out to pay for them. She may, however, deduct a portion of the chairs’ cost each year over their 10-year useful life as a depreciation expense.
It’s important to note that if the household member’s business is losing money, HUD says not to use those business losses to offset other household income [HUD Handbook 4350.3, par. 5-6(H)(3)]. Simply consider the household to have no income from the business. List the business as an income source on the recertification paperwork, but enter “0” as the income amount.
Example #4: The hair salon from Example #1 reports a loss of $3,000 for the past year after deducting business expenses—including the $15,000 and $10,000 salaries for the household member and her daughter—from gross income. When calculating household income, count both salaries but don’t deduct the $3,000 loss. So the household’s income, assuming no other sources, would total $25,000 ($15,000 plus $10,000 plus “0”), not $22,000 ($15,000 plus $10,000 minus $3,000).
How to Verify Net Income of Business
You can use the following documents to verify business income [Handbook 4350.3, App. 4]. These documents show income for the prior year, so you’ll need to review them with the household to estimate income for the upcoming 12-month certification period or to revise that estimated income for an interim recertification.
IRS tax returns. HUD prefers you to use the household member’s federal tax return, including supporting schedules, to verify business income. The Schedule C Profit or Loss from Business form details the gross income and the expenses associated with running the business to support the amount of net income or loss stated on Line 12 of Form 1040. Some households may use a different schedule, including Schedule E Supplemental Income and Loss (for income from rental property, partnerships, and S corporations) or Schedule F Profit or Loss from Farming.
The Form 1040 of the household member who owns the business should show that household member’s salary from the business (along with other wages or salary the member may have earned). You may need to verify the salaries from the business of other household members who filed their own tax returns. You can do this by getting copies of those returns or by having the business owner fill out a notarized statement or the employment verification form you use for other employment situations.
You can verify that the tax return you get from a household is a “true and accurate” copy of the return filed with the IRS. To do this, you can request a “tax return transcript” from the IRS. The transcript details the information reported on a taxpayer’s most recent tax return. To make the request, use IRS Form 4506-T. You must get the household member to sign the form before you submit it to the IRS. Copies of the form are available on the IRS Web site at www.irs.gov.
Accountant’s calculation of depreciation. If the business expenses include depreciation of assets, such as equipment or buildings, be sure to ask what method of depreciation the business used to determine the depreciation expense. If the business uses a depreciation method other than straight-line on its tax return (this type of depreciation would look like an accelerated method that allocates the cost over a shorter period or allows higher deductions in earlier years than in later years), HUD says you also must get from the household an accountant’s calculation of depreciation expense computed using straight-line depreciation rules. Then use this amount to recalculate the net income shown on the return.
Business’s audited or unaudited financial statement(s). Some businesses prepare financial statements and, depending on how the business is organized, must have these statements audited by an independent accountant. If the business has audited financial statements, use them if you can’t get copies of the Form 1040 and schedules. If the business’s statements aren’t audited, or if the accountant hasn’t finished the audit, you can use unaudited statements instead.
Loan application that lists income from the business during the previous 12 months. Often when businesses apply for loans, the bank will ask for recent income information on the loan application. This application is an acceptable way to verify the income if you can’t get income tax returns, says HUD.
Household member’s notarized statement of net business income. Some household members might not file income tax returns or prepare financial statements for the business. In that case, obtain a notarized statement from the household member detailing the income and expenses from the business and the net income amount. This self-declaration is the method of last resort.