This examination consists of three essay questions, each of which will be given equal weight in determining grades. Three hours will be permitted for this examination. At the end of the three hours, you must turn in both this set of essay questions and your answers in the original envelope in which this set came.

All answers must be entered in the bluebooks you have been provided (or, for those typing or operating computers, on separate sheets of plain white paper). No credit will be given for anything written on this set of questions.

Pay close attention to the final portion, or "call," of each question. Failure to respond to the matters called for will result in a low score for the question. On the other hand, discussion of matters outside the scope of the call of the question will not receive credit.

Be sure to explain as thoroughly as possible your answers to the questions posed. Your reasoning, discussion and analysis are often as important as any particular conclusion you reach.

The suggested time limit for each question is one hour. Experience has shown that failure to budget one's time according to this limit can result in a drastic lowering of one's overall grade on this examination.

Unless otherwise instructed, you should assume that:

all partners described in the questions are individuals;

all partners and partnerships described in the questions use the calendar year as their taxable year for federal income tax purposes; and

all partners and partnerships report their income on the cash method for such purposes.

References to "the Code" are to the Internal Revenue Code of 1986, as amended.

Lil and Mort are equal members in a limited liability company, LM, which is classified as a partnership for tax purposes. LM's business is real estate development and management. Its initial assets consist of $100,000 cash, contributed one half each by Lil and Mort. LM then borrows $900,000 from a lender. The debt is an unsecured, recourse loan as to LM; Mort personally guarantees this debt.

LM's operating agreement provides that all income, gain, losses, and deductions are to be allocated equally among the partners. The agreement meets the first two of the three primary requirements for "economic effect" set forth in the regulations under Section 704(b) of the Code. The LLC operating agreement does not require Lil or Mort to restore any negative balance in his or her capital account; however, the agreement includes a "qualified income offset," as defined in the aforementioned regulations, as to both Lil and Mort.

Under the terms of the LM operating agreement, Lil and Mort are required to turn over to LM any funds they receive in exchange for any personal services they perform or have performed -- in the past, present or future -- as real estate managers. After LM is formed, a client of Lil's pays her $5,000 for real estate management services that Lil performed before LM's formation; Lil endorses the check over to LM. On its books, LM treats the funds it receives in this manner as income.

In the first year of its operation, not counting the funds it received from Lil's client, LM has a net operating loss of $150,000.

What are the federal income tax consequences -- to Lil, Mort and LM -- of the transactions just described? Be sure to discuss the amount, timing and character (capital or ordinary) of each item of income, gain, deduction or loss to each party; and each party's basis in the property or interest which that party holds (actually or constructively) at each stage of the transactions.

Discuss.

Amy, Bob and Cal form a limited partnership, ABC, which is classified as a partnership for tax purposes. Amy is the limited partner; Bob and Cal are the general partners. The partnership agreement provides that all income, gain, losses and deductions are to be allocated equally among the partners. As to Bob and Cal, the partnership agreement meets all three primary requirements for "economic effect" under the regulations under Section 704(b) of the Code. As to Amy, the first two requirements are met, but she is not required to restore any negative balance in her capital account; instead, the agreement includes a "qualified income offset," as defined in the aforementioned regulations, as to Amy.

Amy contributes $30,000 cash in the formation of ABC. Bob contributes Blackacre, a parcel of real estate he has held for investment. Blackacre has a fair market value of $90,000, but it is encumbered by a mortgage to a bank, which secures a loan the principal balance of which is $60,000, so that Bob's "equity" in Blackacre is $30,000. ABC assumes the mortgage -- that is, it promises Bob that it will pay it. Bob's basis in Blackacre immediately prior to the contribution is $40,000. Cal contributes his future services to ABC, in return for a one-third interest in ABC's capital and profits; the services will relate to starting up ABC's business.

Immediately after ABC is formed, its balance sheet (book values and capital accounts only) is as follows:
 

What are the federal income tax consequences -- to Amy, Bob, Cal and ABC -- of the transactions just described? Be sure to discuss the amount, timing and character (capital or ordinary) of each item of income, gain, deduction or loss to each party; and each party's basis in the property or interest which that party holds (actually or constructively) at each stage of the transactions.

Explain.

Ruth and Sandra are equal partners in a general partnership, RS, which is classified as a partnership for tax purposes. The assets of RS are as follows:
 

Redacre and Sheepacre are parcels of vacant land that RS is holding for investment. Ruth contributed Redacre to RS, and Sandra contributed Sheepacre to RS, both when RS was formed in 1998; at the time, each parcel had a fair market value of $50,000. No adjustments have been made to the parcels' basis in the hands of RS. Neither Ruth nor Sandra is a real estate dealer; neither was holding the real estate for sale to customers prior to contributing it to RS.

The equity of RS is as follows:
 

RS has no outstanding debts or other liabilities.

In 2001, RS makes operating distributions to the partners. The distributions are not described in Section 707(a) or Section 707(c) of the Code. The distributions are: (1) RS distributes Redacre and $30,000 cash to Ruth, and (2) RS distributes $100,000 cash to Sandra.

What are the federal income tax consequences -- to Ruth, Sandra and RS -- of the distributions, with and without any available elections? Be sure to discuss the amount, timing and character (capital or ordinary) of each item of income, gain, deduction or loss to each party; and each party's basis in the property or interest which that party holds (actually or constructively) at each stage of the actual or deemed transactions.

Discuss.