Partnership Taxation

Spring 2009

Bogdanski

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 on an approved type of computer disk or on separate sheets of plain white paper (or for those writing answers by hand, in the bluebooks you have been provided). 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)

Hank, Irma, and Jared form a limited partnership, named LP. Hank is the sole general partner; Irma and Jared are limited partners.

The LP partnership agreement states that all items of income, loss, deduction, and credit are to be shared equally among the three partners. It also provides that each partner’s capital account will be kept in accordance with the regulations under Section 704 of the Code, and that on any liquidation of LP or of a partner’s interest, each partner’s liquidating distribution will be in accordance with his or her positive capital account balance. Hank also agrees that if his capital account is negative at the time of any liquidation of LP or of his interest, he will promptly restore the negative balance by paying cash in that amount to LP. The agreement contains a “qualified income offset,” as described in the regulations, applicable to Irma and Jared.

In forming LP, Hank and Irma each transfer $24,000 cash in exchange for his or her respective interest in LP. Jared, a real estate dealer, transfers a parcel of unimproved real estate, Greenacre, in exchange for his interest in LP. At the time of the transfer, Greenacre has a fair market value of $54,000, but it is encumbered by a mortgage securing a recourse loan with an outstanding balance of $30,000, so that Jared’s “equity” in the property is $24,000. Immediately before the exchange, Jared’s adjusted basis in Greenacre is $21,000. LP assumes the mortgage.

LP’s primary activity is investment; it makes no improvements to Greenacre. About a year and a half after it is formed, LP sells Greenacre to an unrelated buyer, Betty. In purchasing Greenacre, Betty pays LP $18,000 cash and assumes the mortgage on the property, which still has an outstanding balance of $30,000. Aside from this transaction, LP’s gross income and deductions offset each other exactly each year.

What are the federal income tax consequences of the transactions just described -- to Hank, Irma, Jared, and LP -- 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 Question 1)

QUESTION TWO

(One hour)

Kate, Laura, and Matt are the three equal members of a limited liability company, named KLM, which has been in operation for many years. On May 1, 2009, the balance sheet of KLM is as follows:

	Assets			Liabilities
	Basis	Fair market value		Basis	Fair market value
Cash	$ 51,000	$ 51,000	Debt	$ -0-	$ -0-
Cash (not yet in members’ income*)	3,000	3,000	Equity
Inventory	30,000	42,000	Kate	31,000	41,000
Account receivable	-0-	12,000	Laura	31,000	41,000
Stock (capital asset)	12,000	15,000	Matt	31,000	41,000
			Total equity	93,000	123,000
Total assets	$ 96,000	$123,000	Total liabilities	$ 93,000*	$123,000

* - The $93,000 aggregate members’ basis does not include the $3,000 not previously taken into income.

None of the assets was contributed by any partner to KLM. KLM has no assets besides those listed on its balance sheet. Matt is not active in KLM’s operations.

The KLM operating agreement states that all items of income, loss, deduction, and credit are to be shared equally among the three members. This allocation has substantial economic effect within the meaning of Section 704(b) of the Code.

On May 1, 2009, Matt dies, leaving his entire estate, including his interest in KLM, to his son, Seth. KLM promptly liquidates Matt’s former interest in the company by paying $50,000 cash to Seth. For the year 2009, KLM has gross income (all ordinary) of $120,000 and deductions (also all ordinary) of $111,000, for taxable income of $9,000.

What are the federal income tax consequences of the transactions just described -- to Kate, Laura, Matt, Seth, and KLM – 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.

Explain.

(End of Question 2)

QUESTION THREE

(One hour)

Nate and Olivia form a limited liability company, named Company. Nate contributes $20,000 cash and Olivia contributes $80,000 cash to start Company. Company then borrows $200,000 from a bank. The loan is a recourse loan to Company; because Company is an LLC, however, the members are not personally liable for it.

Company’s operating agreement states that except as otherwise provided in the agreement, all items of income, loss, deduction, and credit are to be shared equally between the two members. It also provides that each member’s capital account will be kept in accordance with the regulations under Section 704 of the Code, and that on any liquidation of Company or of a member’s interest, each member’s liquidating distribution will be in accordance with his or her positive capital account balance. The agreement further contains a “qualified income offset,” as described in the regulations, applicable to Nate and Olivia.

The agreement provides that, regardless of the income of Company, Company will pay $100,000 to Olivia for services that she renders to Company in its first year of operations.

In that first year of operations, not taking into account its transaction with Olivia, Company has ordinary income of $60,000; ordinary deductions of $40,000; and long-term capital gain of $30,000 -- thus, a profit of $50,000. As required by the operating agreement, Company pays Olivia $100,000 for her services during the first year. It makes no other distributions or payments to either member.

What are the federal income tax consequences — to Nate, Olivia, and Company — 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)

Created by: bojack@lclark.edu
Update:  19 May 09
Expires:  31 Aug 10