This examination consists of two essay questions, each of which will be given equal weight in determining grades. Two hours will be permitted for this examination. At the end of the two hours, this set of essay questions and your answers to them will be collected. 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 expressly instructed, assume that all taxpayers described in the questions are individuals, and that they report their income on the cash method and the calendar year for federal income tax purposes. Any references to the "Code" mean the Internal Revenue Code of 1986, as amended.
 
 

Megan, Ned and Oscar form a limited liability company, Lilco. Lilco lacks continuity of life and centralized management. Each member contributes $20,000 cash in exchange for a one-third interest in Lilco's capital, profits and losses.

Lilco promptly borrows $18,000 from a bank; under the loan agreement, the bank has recourse to Lilco's assets. In addition, Megan is personally required to guarantee the Lilco debt.

In the first year of its operation, Lilco has gross income of $90,000 and deductions of $75,000, for an operating profit for tax purposes of $15,000. Of the $90,000 of gross income, $81,000 is ordinary income to Lilco and $9,000 is short-term capital gain; all of its $75,000 of deductions are ordinary deductions.

During that first year, Lilco repays $3,000 of principal to the bank, and pays $4,000 cash to each member as a distribution with respect to his or her interest. The distributions are not described in section 707 of the Code.

What are the federal income tax consequences to Megan, Ned, Oscar and Lilco of the transactions just described? Be sure to explain the amount, timing and character (capital or ordinary) of any income, gain, loss or deduction recognized by each party, and the basis of the LLC interest and assets held by each party, at each stage of the transactions.

Discuss.

On January 15, 1996, Ann and Brenda form an S corporation, Kompany, to engage in investments. On January 15, 1996, Ann contributes to Kompany a parcel of land, Deal-acre, that Ann has been holding for sale to her customers in her business as a real estate dealer. Deal-acre has an adjusted basis in Ann's hands of $100,000; its fair market value is $200,000, but it is encumbered by a long-standing mortgage securing a recourse loan with an outstanding principal balance of $120,000, so that Ann's equity in the property is $80,000. (Ann used the loan proceeds in her business.) Kompany assumes the mortgage liability on Deal-acre, and it issues to Ann 80 shares of its common stock, with a fair market value of $1,000 each.

Also on January 15, 1996, Brenda receives 20 shares of Kompany common stock, each with a fair market value of $1,000, in exchange for $20,000 cash. Brenda agrees to, and does, personally guarantee the loan, now assumed by Kompany, which is secured by Deal-acre; since Ann remains liable under the original loan document, both Brenda and Ann are now personally liable for the debt if Kompany does not pay it.

On December 15, 1996, Kompany sells Deal-acre to Percy for $85,000 cash, plus assumption of the debt encumbering it. On the sale date, the principal balance on the debt is still $120,000. For all of its other transactions during 1996, Kompany "breaks even" -- i.e., its gross income and deductions offset each other exactly.

What are the federal income tax consequences to Ann, Brenda and Kompany of each of the transactions just described? Be sure to explain the amount, timing and character (capital or ordinary) of any income, gain, loss or deduction recognized by each party, and the basis of the stock and assets held by each party, at each stage of the transactions.

Explain.