Chapter 32 — Exercises

Thirty-four items, graduated from recall to full file judgment. Items marked † have worked solutions in the answers appendix; the rest are for your own working, your study group, or your manager.

Every cash-flow problem below is a constructed teaching example. Form 1084, Form 1088, and Freddie Mac's Form 91 are real published worksheets and are revised — work the problems with the principles in this chapter, then repeat one of them against the current form and see what moved.

Show your arithmetic. In this chapter, an answer without arithmetic is an opinion.

A. Recall and reasoning

32.1 Name the four business structures covered in this chapter, the federal return each one files, and whether the entity pays federal income tax on its own earnings.

32.2 Which two structures produce a Schedule K-1 for the owner? Which one normally produces both a W-2 and a K-1 from the same company, and why does that structure require it?

32.3 † State the add-back principle in one sentence, then use it — without consulting any list — to classify each of the following: a \$9,400 depreciation deduction; a \$7,200 annual vehicle lease; a \$4,000 insurance settlement received; the nondeductible half of \$6,800 of business meals; a \$31,000 payroll expense.

32.4 A borrower says, "I take \$11,500 a month out of my S-corp." Explain in three sentences why that statement, standing alone, tells you almost nothing about their qualifying income — and name the one clarifying question that resolves it.

32.5 A borrower tells you they "have an LLC." Explain why that sentence does not tell you which documents to request, and write the follow-up question you would actually ask.

32.6 List three items that are add-backs on a cash-flow worksheet and three items that are real business expenses and are not add-backs. For each of the six, say which half of the add-back test it fails or satisfies.

32.7 Why does a sole proprietor's business-use-of-home deduction get added back, while the rent a business pays on a commercial unit does not?

32.8 "Amortization" appears in two completely different senses in this book. Define both, name the chapter that owns each, and explain why confusing them would cause a loan officer to add back a number that has nothing to do with the business.

B. Cash-flow analyses

Four full analyses across four structures. For each: compute the annual total for both years, the monthly figure for each year, the 24-month average, the direction and percentage of the trend, and the qualifying monthly income the underwriter would use. State which averaging rule you applied and why.

32.9 † Sole proprietorship (Schedule C). A freelance industrial photographer, six years in business, files a Schedule C.

32.10 † Partnership (Form 1065). A 40% partner in a four-partner civil engineering firm. The partnership's own figures are shown at 100%; convert them yourself.

32.11 † S-corporation (Form 1120-S). A 100% shareholder of a commercial cleaning company. In year 2 the company suffered an uninsured casualty loss when a water main flooded its warehouse; the loss is documented and one-time.

32.12 † C-corporation (Form 1120). A 100% shareholder of a specialty manufacturer. The corporation's retained earnings grew by \$140,000 across the two years.

State what you may count, what you may not, and what conditions attach to each item you counted. Then answer: what would you need before you were willing to count the dividends at all?

32.13 † Return to exercise 32.11. Recompute it with the casualty-loss add-back removed — that is, assume the underwriter declines to treat the loss as non-recurring because the borrower cannot document it. Compute the new year 2 total, the new decline percentage, and the new qualifying income. In one paragraph, describe what that single condition is worth to this file and what evidence you would go get.

32.14 † Return to the Fulton Avenue worksheet in §32.7. Recompute the entire analysis on one changed assumption: the year 2 nonrecurring other income subtraction is \$5,000 rather than \$0 — the borrower sold a used compressor. Compute the new year 2 total, the new monthly figures, the new 24-month average, the new decline percentage, and the qualifying income. Then answer: does the decline change category, and what would you now ask the borrower for?

C. Applied structuring

32.15 † A self-employed borrower's cash-flow analysis produces \$8,916.67 of qualifying monthly income. They carry \$1,100.00 of monthly consumer debt.

(a) At a 45% back-end ratio, what is the maximum PITI the file supports? (b) At a 43% back-end ratio, what is it? (c) State the difference in dollars, and explain in one sentence to a borrower what the two percentages represent and why you cannot promise the higher one.

32.16 The same borrower has \$34,000 in personal savings, \$18,000 available as a gift from a parent, and a business checking account holding \$61,000. They need \$44,000 to close. Rank the three sources by how much work each will cost the file, name the specific documentation each requires (citing the chapter that owns it), and recommend a structure. Defend the recommendation in three sentences.

32.17 † Business liquidity. A borrower who owns 100% of an S-corporation wants to withdraw \$35,000 for a down payment. The corporation's year-end balance sheet shows:

(a) Compute the current ratio and the quick ratio before the withdrawal. (b) Compute both after a \$35,000 withdrawal. (c) Identify the problem that neither ratio shows, and state it in one sentence. (d) Write the two questions you would ask the borrower before going any further.

32.18 A borrower's income declined 9% year over year. Which of the following explanations would you submit, which would you send back for rewriting, and why? For each one you would submit, name the document that has to accompany it.

1. "We had a slow year but things are picking up."
2. "We lost our largest customer in March when they were acquired. We replaced roughly 70% of that revenue with two new accounts signed in September and October."
3. "My accountant found more deductions this year."
4. "I had surgery in February and was out of the field until late May. My two crews kept working but we could not take on new estimates."
5. "The economy."

32.19 † Read the document and find the problem. A borrower's Form 1120-S K-1 shows \$47,000 of ordinary business income for the most recent year. Their personal bank statements show consistent monthly transfers of \$14,000 from the business account. The business's balance sheet shows cash falling from \$310,000 to \$96,000 over the same year, and no new borrowing.

Reconstruct what happened, state the qualifying income implication, and name the underwriting concern that is larger than the arithmetic.

32.20 Write the complete initial document request you would send a first-time self-employed borrower who owns 100% of an S-corporation, as a single message they could act on without calling you back. Then write the two-sentence explanation you would put above the list so it does not feel like an interrogation.

D. Documents and conditions

32.21 † Clear the condition. Underwriting has conditioned for "a letter from the borrower's CPA confirming that the withdrawal of \$40,000 from the business will not have an adverse impact on the business's operations." The CPA has declined to sign it, stating that they are engaged only to prepare returns and will not issue an assurance opinion.

Write the response you send to underwriting. It should propose at least two alternative forms of evidence and explain what each one demonstrates.

32.22 Draft the prompt you would send a borrower asking them to write a business narrative — the actual words, not a description of them. Keep it under 120 words and make it answerable in ten minutes.

32.23 † A borrower calls: "My accountant says we can amend last year's return, take out the Section 179 deduction, and my income goes up by forty grand. Can we do that?"

Write your answer, verbatim, in under 100 words. Then list, separately, the three reasons your answer is what it is.

32.24 A borrower owns 35% of a partnership. List every document you request, and for each one, name the specific fact you are trying to establish. Include at least one document you would request because the ownership is below 100%.

32.25 † A borrower's file arrives with a W-2 and paystubs from a company. On the application call they mention offhand that they "own a piece of the place." You establish that it is 30%.

State what changes about the file, what you now request, what you tell the real estate agent about the timeline, and what you do not say to the borrower.

32.26 A seasonal landscaping S-corporation's balance sheet is dated December 31. Explain why that date is close to the worst possible date for judging this business's liquidity, name the month you would rather see, and say what you would request in place of — or in addition to — the year-end statement.

E. Judgment and ethics

32.27 † A borrower's CPA calls you directly: "Just tell me which deductions to leave off next year's return and I'll make the numbers work for them."

Write your answer. Then explain, in two sentences each: why this is not your decision to make, why answering it anyway would be a problem, and what you can offer the CPA that is genuinely useful.

32.28 A borrower's income declined 4%. They ask you to "just use last year, it was higher — the average is basically the same anyway." Explain why you cannot, in language a business owner will accept, without blaming an anonymous underwriter.

32.29 † A referral partner who has sent you nine files this year calls at 4:40 on a Friday: their client is self-employed, is writing an offer tonight, and needs a pre-approval letter in an hour. The borrower has not sent tax returns.

State exactly what you do. Then state what you say to the agent, in the words you would use. Then state the cost of the alternative — issuing the letter — in specific terms.

F. NMLS-style questions

32.30 A borrower owns 100% of a business that files Form 1120 and pays federal income tax on its own earnings. Which of the following is the borrower's income for qualifying purposes?

• A. The corporation's net profit
• B. The corporation's retained earnings
• C. W-2 wages and dividends received from the corporation
• D. The corporation's gross receipts less operating expenses

32.31 Which federal return does a multi-member LLC that has made no entity classification election file?

• A. Schedule C
• B. Form 1065
• C. Form 1120-S
• D. Form 1120

32.32 A shareholder receives a \$90,000 distribution from an S-corporation whose K-1 reports \$34,000 of ordinary business income. For qualifying purposes, the loan originator should:

• A. Count \$90,000, because it is the cash the borrower actually received
• B. Count \$124,000, because both amounts were received
• C. Count the \$34,000 of K-1 income, adjusted, and treat the distribution as a fact about the business rather than as income
• D. Count \$56,000, the difference between the two

32.33 Which of the following is NOT typically an add-back on a self-employed cash-flow analysis?

• A. Depreciation
• B. Depletion
• C. A monthly vehicle lease payment deducted by the business
• D. Amortization of goodwill

G. The Loan File

32.34 † Extend the Chapter 32 overlay. Re-run the self-employed Borrower 2 worksheet from the 🗂️ The Loan File checkpoint with one change: the meals and entertainment exclusion is halved in both years — \$2,100 in year 1 and \$2,400 in year 2 — because the borrower moved most client entertainment to a company that reimburses it.

(a) Recompute both annual totals, the 24-month average, and the trend. (b) Recompute the total qualifying income, the housing ratio, and the back-end ratio. (c) State how many points of back-end ratio the meals exclusion alone was costing this file. (d) Then answer the question that matters: does this change what you would tell the borrower on day one, and if not, why did you compute it?