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.
 
 

Chris, Davis and Edna are the members of a limited liability company known as CDE. The assets of CDE, which was formed in 1998 and has never made any elections as to its classification for federal tax purposes, are as follows:
 

Asset	Basis to CDE	Fair market value
Cash	$30,000	$30,000
Account receivable	-0-	40,000
Inventory	30,000	50,000
Stock in publicly traded company	40,000	80,000
Total	$100,000	$200,000

None of the assets, other than the cash, was contributed to CDE by any member.

CDE has only one liability, a long-term debt to a bank, with a currently outstanding principal balance of $80,000. The debt is unsecured and there are no guaranties. Under CDE's operating agreement, income, gain, losses and deductions are shared as follows: 50 percent to Chris, 25 percent to Davis, and 25 percent to Edna. The members' equity is as follows:
 

Member	Basis of interest	Fair market value
Chris	$ 50,000	$ 60,000
Davis	25,000	30,000
Edna	25,000	30,000
Total	$100,000	$120,000

Edna sells her interest in CDE to Pearl for $30,000 cash.

What are the federal income tax consequences -- to Chris, Davis, Edna, Pearl and CDE -- of this transaction, 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; 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; and CDE's balance sheet (basis and fair market values) immediately thereafter.

Discuss.

In 1999, Lisa and Monty form a limited liability partnership. Lisa contributes $100,000 worth of land to the partnership upon its formation. Lisa's basis in the land immediately before the contribution is $100,000. Monty, a securities dealer with a seat on a major stock exchange, contributes corporate stock with a fair market value of $100,000. Monty's basis in the stock immediately before the contribution is $30,000; he had been holding it for sale to customers.

The partnership agreement provides that Lisa and Monty will share all income, gain, loss, deduction and credit equally. The agreement meets all the requirements for substantial economic effect under the regulations promulgated under Section 704 of the Code.

The partnership is not an "investment company" as described in Section 351(e) of the Code, nor is it a securities dealer. It makes no elections as to its classification for federal tax purposes.

In 2000, in a transaction not contemplated when the partnership was formed, a new partner, Newton, is admitted to the partnership. At the time of Newton's admission, the land has retained its original fair market value of $100,000, but the stock is now worth $140,000. The partnership adjusts the book value of the stock to $140,000 just prior to Newton's arrival. At that point, the partnership's assets are:
 

Asset	Book value
Cash	$ 18,000
Receivables	7,000
Land	100,000
Stock	140,000
Total	$ 265,000

The partnership's only liability at this point is a short-term unsecured debt of $25,000.

Newton pays the partnership $120,000 cash and is admitted as a one-third partner.

In 2001, the partnership sells the stock to an outside party for $170,000 cash.

What are the federal income tax consequences -- to Lisa, Monty, Newton and the partnership -- of all 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; each party's basis in the property or partnership interest which that party holds (actually or constructively) at each stage of the actual or deemed transactions; and the partnership's balance sheet (basis and book values) immediately thereafter.

Explain.
 
 

Rick is the sole general partner and Sally and Tina are the limited partners in a limited partnership known as RST. RST is treated as a partnership for federal tax purposes. As of the end of 1998, Rick's basis in his partnership interest is $100,000; Sally and Tina have a basis in their respective partnership interests of $250,000 each. As 1998 ends, each partner also has a capital account equal (both in book value and fair market value) to the basis of his or her respective partnership interest.

In 1999, RST borrows $2,400,000 from a lender on a nonrecourse basis, and uses the loan proceeds along with $600,000 of its own cash to build Greenacre, a building situated on land that RST has leased on a long-term basis. The nonrecourse loan calls for the payment of interest only for the first four years of its term; it is RST's only debt. Assume that the proper depreciation system for Greenacre is 10-year straight-line depreciation without any applicable convention, so that the partnership's depreciation deduction attributable to the building is $300,000 each year, beginning with 1999.

The partnership agreement provides that capital accounts will be kept in accordance with the regulations under Section 704(b) of the Code, and that positive capital account balances will be honored on any liquidation of the partnership. Under the agreement, however, no partner is required to restore any negative capital account balance, and state law contains no such requirement, either. The agreement states that all partnership losses and deductions, including depreciation on the building, will be shared 20 percent by Rick, and 40 percent each by Sally and Tina. Under the agreement, partnership income and gain will be shared 50 percent by Rick, and 25 percent each by Sally and Tina. The agreement also contains a "qualified income offset" as described by the regulations, and it provides that no distributions shall be made until 2003.

In 1999, 2000 and 2001, the partnership's income and deductions just happen to offset each other exactly, except for the depreciation on Greenacre. Thus, the partnership shows a tax loss of $300,000 in each of the three years.

Answer each of the following questions:

A. How much of the partnership's loss may be deducted by each of Rick, Sally and Tina for each of the years 1999, 2000 and 2001?

B. How would the answer to Question A be different (if at all) if the agreement called for the depreciation to be allocated 50 percent to Rick, and 25 percent each to Sally and Tina?

Discuss.