Chapter 32 — Self-Check Quiz

Twenty-five questions: multiple choice in the style of the SAFE MLO test, plus short answers where the reasoning matters more than the recall. Work them without the chapter open. The answer key is in the collapsed block at the bottom.

Multiple choice

1. Which of the following business entities pays federal income tax on its own earnings?

  • A. Sole proprietorship
  • B. Partnership
  • C. S-corporation
  • D. C-corporation

2. A borrower owns 100% of an S-corporation and works in the business. Which set of income documents should the loan originator expect from the company?

  • A. A W-2 only
  • B. A Schedule K-1 only
  • C. Both a W-2 and a Schedule K-1
  • D. A Schedule C

3. A sole proprietor reports business activity on:

  • A. Form 1065
  • B. Schedule C of Form 1040
  • C. Form 1120-S
  • D. Schedule E, Part II

4. Which federal return does a partnership file?

  • A. Form 1040
  • B. Form 1065
  • C. Form 1120
  • D. Form 1120-S

5. Depreciation is added back on a cash-flow analysis because:

  • A. It is not a legitimate business expense
  • B. It was deducted on the return but no cash left the business in that year
  • C. Cash left the business but it was never deducted
  • D. The IRS requires lenders to disregard it

6. The meals and entertainment exclusion is subtracted on a cash-flow analysis because:

  • A. Meals are never a legitimate business expense
  • B. The deduction was taken twice on the return
  • C. The nondeductible portion is money that left the business and was never deducted
  • D. It is a non-cash expense

7. Which of the following is not typically an add-back?

  • A. Depletion
  • B. Amortization of goodwill
  • C. Rent paid on the business's commercial unit
  • D. A documented one-time casualty loss

8. A borrower's most recent year of self-employment income is lower than the prior year. The underwriter will generally:

  • A. Average the two years to smooth the result
  • B. Use the higher year, because it demonstrates capacity
  • C. Use the lower figure, normally the most recent year, and require an explanation
  • D. Disregard both years and require a fifth year of returns

9. A shareholder receives \$120,000 of distributions from an S-corporation whose K-1 reports \$38,000 of ordinary business income. For qualifying purposes:

  • A. \$120,000 is countable because it was actually received
  • B. \$158,000 is countable because both amounts reached the borrower
  • C. The \$38,000 of K-1 income is the countable figure, adjusted; the distribution is a fact about the business
  • D. Neither figure may be used without a fourth year of returns

10. A borrower says, "I own an LLC." What does that tell you about which federal return to request?

  • A. It files Form 1065
  • B. It files Form 1120-S
  • C. It files a Schedule C
  • D. Nothing — an LLC is a state-law entity and may be taxed under any of several classifications

11. On a partnership file, add-backs taken from the Form 1065 must be:

  • A. Counted in full, regardless of the borrower's ownership share
  • B. Prorated to the borrower's ownership percentage as shown on the K-1
  • C. Ignored entirely, because they belong to the partnership
  • D. Doubled, to account for the partner's basis

12. Which of the following is the best description of what the current ratio measures?

  • A. The business's profitability over the tax year
  • B. Whether the business's short-term assets cover its short-term obligations
  • C. The owner's personal reserves after closing
  • D. The percentage of receivables more than ninety days old

13. A C-corporation's retained earnings are:

  • A. Qualifying income to a 100% shareholder
  • B. Qualifying income only if the shareholder documents access
  • C. The corporation's money, and not the shareholder's qualifying income
  • D. Added back on the cash-flow worksheet as a non-cash item

14. Guaranteed payments reported on a Schedule K-1 (Form 1065) are:

  • A. Distributions, and therefore not income
  • B. Compensation to a partner for services, and generally countable income
  • C. A non-cash deduction requiring an add-back
  • D. The partnership's tax liability allocated to the partner

15. A borrower's self-employment income rose 22% from year 1 to year 2. The conservative convention generally produces a qualifying figure that is:

  • A. Higher than the most recent year alone
  • B. Lower than the most recent year alone
  • C. Identical to the most recent year alone
  • D. Unavailable until a third year is filed

16. Which of the following most accurately describes Fannie Mae Form 1084?

  • A. A required borrower disclosure delivered within three business days of application
  • B. A published worksheet for converting self-employed tax returns into qualifying monthly income
  • C. The automated underwriting findings report for self-employed files
  • D. A federal tax form the borrower signs authorizing release of transcripts

17. A loan officer is analyzing a Schedule C and finds a large deduction for the business use of the home. On the cash-flow worksheet this figure is generally:

  • A. Subtracted, because the household spent the money
  • B. Added back, because it is largely an allocation of costs the household pays regardless
  • C. Ignored, because it appears on the personal return
  • D. Treated as a monthly debt obligation

18. Before using business funds for a down payment, agency guidelines generally require:

  • A. Nothing beyond ordinary asset sourcing, because the funds are in a verified account
  • B. That the borrower be an owner and that the lender confirm the withdrawal will not negatively affect the business
  • C. That the business be an S-corporation
  • D. That the borrower's ownership be below 25%

Short answer

19. State the add-back principle in one sentence, in a form a reader could apply to a line item they have never seen.

20. A borrower's accountant tells them they make \$9,500 a month. The cash-flow analysis produces \$8,916.67. Explain, in three sentences a business owner would accept, why both numbers can be correct.

21. Complete this analysis. Year 1 total: \$109,500. Year 2 total: \$107,000. Compute (a) each year's monthly figure, (b) the 24-month average, (c) the percentage change, and (d) the qualifying income the underwriter will use, with the reason.

22. Name three things an accountant letter can usefully confirm and two things it cannot do.

23. A business's balance sheet shows current assets of \$132,000 (including \$23,000 of inventory) and current liabilities of \$74,000. Compute the current ratio and the quick ratio, then recompute both after a \$40,000 cash withdrawal. State the question the ratios do not answer.

24. A borrower asks whether they should take fewer deductions next year so they can qualify for more. Write your answer in under sixty words, and name the two things you must not do in it.

25. Why is the timing of the self-employment conversation — day three versus day thirty — worth more to a borrower than any rate concession a loan officer could offer? Answer in two sentences.

Answer key — work the questions first **1. D.** The C-corporation is the only one of the four that is taxed as a separate entity on its own earnings. The other three are pass-through structures. **2. C.** An S-corporation owner-employee takes reasonable compensation as W-2 wages and receives a K-1 for their share of the corporation's profit. Both count, and missing either one misstates the file in an obvious direction. **3. B.** Schedule C, *Profit or Loss From Business*, inside the personal Form 1040. There is no separate business return. **4. B.** Form 1065 — an information return; the partnership generally pays no federal income tax itself. **5. B.** The cash left the business in the year the asset was purchased. The deduction arrives in slices in later years, so taxable income understates the cash the business generated in those years. **6. C.** Only a portion of business meals is deductible; the business paid for all of them. The nondeductible portion is cash out with no corresponding deduction, so taxable income *overstates* available cash by that amount. **7. C.** Rent is an ordinary operating expense: money left the business and it was deducted. Both halves of the test point to "leave it alone." A, B, and D are all non-cash or non-recurring items. **8. C.** You do not get to average a declining stream up. The starting position is the lower figure, normally the most recent year, plus an explanation that names a cause. A severe or accelerating decline may mean the agency path does not work at all — see Chapter 34. **9. C.** A distribution is a transfer of already-taxed earnings, not a measure of what the business earned. Counting it would count the same dollar twice. The gap between \$120,000 and \$38,000 is still informative: it says the company is distributing well beyond current earnings. **10. D.** An LLC is a state-law entity, not a tax classification. A single-member LLC with no election files a Schedule C; a multi-member LLC with no election files Form 1065; either may elect S-corporation treatment. Ask which return it files. **11. B.** The K-1 reports the borrower's ownership percentage, and business-return add-backs are prorated to it. A 40% partner in a partnership that deducted \$40,000 of depreciation gets a \$16,000 add-back, not \$40,000. **12. B.** Current assets ÷ current liabilities. Above 1.0 means short-term assets cover short-term obligations. It is a snapshot on one date and is not, by itself, the answer to whether a withdrawal is safe. **13. C.** The corporation is a separate taxpayer and a separate legal person. Its retained earnings are not the shareholder's income, however completely the shareholder controls the company. **14. B.** Guaranteed payments are compensation to a partner for services or for the use of capital, paid regardless of profitability — economically much closer to a salary than to a profit share. **15. B.** Averaging twenty-four months of a rising stream produces a figure below the most recent year. This is the same sting Chapter 11 identified for variable income, and it applies here unchanged. **16. B.** Form 1084 is Fannie Mae's published Cash Flow Analysis worksheet; Form 1088 is the Comparative Income Analysis and Freddie Mac's counterpart is Form 91. All are revised periodically — work from the current version. **17. B.** The business-use-of-home deduction is largely an allocation of household costs — utilities, insurance, depreciation on the residence — that the household pays whether or not the business exists. The worksheet has a line for it. **18. B.** The borrower must be an owner, and the lender must generally confirm that the withdrawal will not negatively affect the business. The Selling Guide is the authority and is updated continuously; verify the current requirement and your lender's overlays. **19.** *Add back what was deducted and did not leave the business; subtract what left the business and was not deducted.* Both halves are necessary — the first produces the add-backs, the second produces the meals exclusion and the short-term-notes subtraction. **20.** Something close to: "Your accountant is telling you what your household has to live on, and they are right. The worksheet I have to use starts from the taxable income on your return, and your accountant's job for two years was to make that number as small as the law allows — they did it well. So the qualifying figure comes in lower than what you actually take home, and that is a feature of how the two professions work, not a judgment about your business." **21.** (a) \$109,500 ÷ 12 = **\$9,125.00**; \$107,000 ÷ 12 = **\$8,916.67** (b) (\$109,500 + \$107,000) ÷ 24 = \$216,500 ÷ 24 = **\$9,020.83** (c) \$109,500 − \$107,000 = \$2,500; \$2,500 ÷ \$109,500 = **2.3% decline** (d) **\$8,916.67** — income declined, so the lower figure applies and averaging up is not available. The averaging rule alone costs this borrower about \$104 a month. **22.** *Can confirm:* that the accountant prepares the returns; that the business has operated continuously since a stated date; the borrower's ownership percentage; sometimes that the accountant is unaware of anything preventing a withdrawal. *Cannot do:* substitute for the returns themselves; create income the return does not support. A third, practical limit: many CPAs will not sign an opinion on the business's viability or on the impact of a withdrawal, because it is an assurance opinion carrying professional liability. Have a plan B before you request one. **23.** Before: current ratio \$132,000 ÷ \$74,000 = **1.78**; quick ratio (\$132,000 − \$23,000) ÷ \$74,000 = \$109,000 ÷ \$74,000 = **1.47**. After a \$40,000 withdrawal: current ratio \$92,000 ÷ \$74,000 = **1.24**; quick ratio \$69,000 ÷ \$74,000 = **0.93**. What the ratios do not answer: whether the business can meet its next payroll, its next tax deposit, and its next equipment payment without borrowing — which depends on *cash*, not on current assets, and on when the receivables actually arrive. **24.** Something close to: "I'm not your tax advisor and I can't tell you how to file. What I can tell you is that qualification runs off the taxable income on your return, so there's a real trade-off between tax saved and borrowing capacity. That's a conversation for you and your accountant, and I'm happy to be on the call to price the mortgage side." The two things you must not do: give tax advice, and suggest amending a filed return. **25.** On day three the news costs nothing — the borrower adjusts their search, and the loan officer who delivered it becomes the one they trust. On day thirty the same news arrives with an accepted contract, an appraisal already paid for, earnest money at risk, and a seller who has taken the house off the market, and no rate concession available to anyone is worth as much as the six weeks that were not wasted.