Partnership Taxation
Spring 2011
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)
KLM is a
limited liability company that has not elected to be taxed as an
association. Capital is a material
income-producing factor for KLM. KLM’s
operating agreement, which fully complies with the regulations under section
704(b) of the Code, provides that all income, gains. losses,
and deductions of KLM are to be shared equally by its three members –
KLM has the following balance sheet as of the end of 2011:
|
|
Assets |
|
|
Liabilities |
|
|
|
Adjusted
basis |
Fair
market value |
|
Adjusted
basis |
Fair
market value |
|
Cash |
$
270,000 |
$
270,000 |
Bank debt |
|
$ 90,000 |
|
Account receivable |
-0- |
90,000 |
Members’ capital: |
|
|
|
Land held for investment |
45,000 |
90,000 |
Karla |
$
105,000 |
$
120,000 |
|
|
|
|
|
105,000 |
120,000 |
|
|
|
|
Melanie |
105,000 |
120,000 |
|
|
|
|
Total members’ capital |
$
315,000 |
$
360,000 |
|
Total assets |
$
315,000 |
$
450,000 |
Total liabilities |
$
315,000 |
$
450,000 |
Neither the account receivable nor the land was contributed to KLM by either member.
On January
1, 2012 – a day on which KLM conducts no business and has no income or
deductions – KLM pays $144,000 cash to
What are the federal income tax consequences of the transaction
just described – to
Discuss.
(End of Question
1)
QUESTION TWO
(One hour)
Sue, Terry, and Ursula form a general partnership known as STU. STU does not elect to be taxed as an association, and it would not be an “investment company” as described in section 351(e) of the Code if it were incorporated.
On January 2, 2011, each of the partners makes a capital contribution of $120,000 to form STU. Terry and Ursula make their contributions in cash. Sue contributes to STU a building (and a lease, with zero market value, on the underlying land). On the date of the contribution, the building has a fair market value of $180,000 and an adjusted basis to Sue immediately before the contribution of $360,000. It is subject to a recourse mortgage securing a debt of $60,000 that Sue owed to a bank immediately before the contribution; STU assumes this debt.
The building is depreciable. For purposes of this question, assume that the partnership will be entitled to depreciate the building using the straight-line method over a 10-year period, with no depreciation conventions, for a depreciation deduction for income tax purposes of $36,000 per taxable year. Assume that if the partnership were purchasing the building in an arm’s-length transaction from a stranger, it would be required to depreciate the building using the straight-line method over a 30-year period, with no depreciation conventions.
For 2011, other than the depreciation deduction on the building, STU's gross income and its deductions just happen to offset each other exactly. The depreciation deduction, however, creates a $36,000 operating loss to the partnership for the taxable year. STU repays no principal on the debt in 2011, nor does it make (or plan to make) any distributions to the partners for the foreseeable future.
The partnership agreement provides that all items of income, gain, loss, and deduction shall be allocated equally among the partners. The partnership agreement satisfies all of the “big three” requirements for substantial economic effect under the regulations under section 704(b) of the Code.
What are the federal income tax consequences for 2011 – to Sue, Terry, Ursula, and STU – of the transactions just discussed, 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 transactions.
Explain.
(End of Question
2)
QUESTION THREE
(One hour)
Amy and Bart are the only members of a limited liability company, AB, which has not elected to be taxed as an association and would not be an “investment company” as described in section 351(e) of the Code if it were incorporated. The operating agreement of AB provides that the members’ capital accounts will be maintained in accordance with the regulations under Section 704(b) of the Code, and that upon liquidation of the LLC, distributions to members will be made in accordance with their respective positive capital accounts. The agreement does not require either member to make any additional outlays of cash or property, beyond the initial contributions they made to form AB.
AB’s balance sheet at the start of 2011 shows $100,000 cash, two other assets, and no liabilities. The noncash assets (both capital assets in AB’s hands) are a tax-exempt state government bond, with an adjusted basis, book value, and fair market value of $50,000; and preferred stock in a publicly traded utility company, with an adjusted basis, book value, and fair market value of $40,000. The bond bears interest at a fixed rate, with no principal to be paid until 2021, and the preferred stock pays a fixed annual dividend. Each of the two members starts 2011 with an LLC interest that has an adjusted basis, book value, and fair market value of $95,000.
The AB operating agreement allocates all of the tax-exempt interest income from the state government bond to Amy, and all of the dividends from the preferred stock to Bart. In 2011, the bond produces interest income of $4,000, and the preferred stock produces dividend income of $5,000. The operating agreement allocates all other income of the LLC between the two members equally; AB’s only 2011 income other than the bond interest and dividend is $2,000 of taxable interest income on its bank account. AB has no deductions and makes no distributions to its members in 2011.
In March 2012, Bart transfers to AB a parcel of unimproved real estate, Blackacre, that Bart has been holding for investment. Bart’s adjusted basis in Blackacre immediately before the transfer is $35,000, and Blackacre’s fair market value at the time is $40,000; the property is not subject to any liabilities. Nine months later, AB transfers $61,000 cash to the two members – $10,000 to Amy and $51,000 to Bart. On its books, AB treats the transfer of Blackacre as a contribution to the company’s capital by Bart, increasing the book value of his LLC interest by the fair market value of Blackacre. AB reduces the book values of Amy’s and Bart’s capital accounts by the respective amounts of money it pays to each of them. AB’s gross income and deductions for 2012 just happen to offset each other exactly, so that its taxable income is zero.
What are the federal income tax consequences — to Amy, Bart, and AB — 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 (actually or constructively), at each stage of the transactions.
Discuss.
(End of examination)
Created by: bojack@lclark.edu
Update: 14 May 11
Expires: 31 Aug 12