FINAL EXAMINATION

(Three hours)

INSTRUCTIONS

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 or a computer floppy disk). 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.

QUESTION ONE

(One hour)

Mark, Nancy, and Olivia form a general partnership, MNO, which is treated as a partnership for federal tax purposes. The partnership agreement provides that all the income, gain, deduction, loss, and credit of MNO shall be allocated 50 percent to Mark; 25 percent to Nancy; and 25 percent to Olivia. The partnership agreement complies with all of the "big three" requirements for economic effect under section 1.704-1(b)(2)(ii)(b) of the Treasury regulations.

Mark and Nancy each contribute $100,000 cash in exchange for his or her respective partnership interest. In exchange for her partnership interest, Olivia contributes a portfolio of stocks and bonds, with a fair market value of $400,000 and a basis to Olivia of $400,000; the portfolio is subject to a security interest (mortgage) securing a recourse loan with an outstanding principal balance at the time of the contribution of $300,000, so that Olivia's "equity" in the portfolio is $100,000. MNO assumes the $300,000 recourse debt.

During the first year of its operations, MNO repays $40,000 of principal on the loan, plus interest on the outstanding balance throughout the year. MNO's gross income and deductions (including interest paid) for the year just happen to offset each other exactly. At the end of the year, MNO's balance sheet shows assets with an aggregate basis and book value of $560,000.

Answer each of the following questions:

A. What is the basis of each partner's interest in MNO immediately after its formation, and at the end of the first year of its operations?

B. How, if at all, would your answer to Part A above be different if the loan were a nonrecourse loan?

Discuss.

(End of Question 1)

QUESTION TWO
(One hour)

Dora, Emma, and Fiona are the members of a limited liability company (LLC) called DEF. DEF is treated as a partnership for federal income tax purposes. Under the DEF operating agreement, which has substantial economic effect, all its income, gain, deduction, loss, and credit are shared equally among the three members. The balance sheet of DEF is as follows:

Assets			Liabilities
	Basis	Fair market value		Basis	Fair market value
Cash	$ 30,000	$ 30,000	Debt
Accounts receivable	-0-	15,000	Bank		$ 27,000
Publicly traded stock	24,000	18,000	Equity
Real estate held for investment	60,000	72,000	Dora	$ 38,000	36,000
			Emma	38,000	36,000
			Fiona	38,000	36,000
Total assets	$ 114,000	$ 135,000	Total liabilities	$ 114,000	$ 135,000

The bank debt is unsecured, and none of the members has guaranteed it. Each member has held her LLC interest for several years.

Dora sells her entire LLC interest to Pete for $36,000 cash.

What are the federal income tax consequences of the sale -- to Dora, Emma, Fiona, Pete, and DEF -- with and without all 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 before and after the transaction.

Explain.

(End of Question 2)

QUESTION THREE

(One hour)

Jeff and Karen, unrelated taxpayers, form a limited liability company (LLC) called JK. JK is treated as a partnership for federal income tax purposes. The LLC operating agreement states that all of JK's income, gain, deduction, loss, and credit will be shared equally by Jeff and Karen. The agreement complies with the first two of the "big three" requirements for economic effect under section 1.704-1(b)(2)(ii)(b) of the Treasury regulations. However, only Karen is required to restore any negative balance in her capital account upon liquidation of JK or her interest therein. As to Jeff, the operating agreement contains a "qualified income offset," as described elsewhere in the regulations.

Each partner contributes $50,000 in exchange for his or her LLC interest. JK borrows $60,000 from a bank. The debt is properly allocable equally to the two partners.

For the first year of its operations, JK has $25,000 of gross income and $135,000 of deductions, for a net operating loss of $110,000, all from rental operations.

Early the next year, Jeff contributes to JK a machine for use in JK's business. Jeff's adjusted basis in the machine is $20,000, and its fair market value at the time of the contribution is $15,000. A few months later, before any depreciation deductions are taken on the machine, JK sells it to an unrelated purchaser for $16,000 cash. The sale was not planned or contemplated when Jeff contributed the machine to JK.

What are the federal income tax consequences -- to Jeff, Karen, and JK -- of the transactions just described, with and without all 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, at each stage of the transactions.

Discuss.

(End of examination)