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, 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 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. References to the "Code" are to the Internal Revenue Code of 1986, as amended.
 
 

Art, Brenda and Crystal form an S corporation, Sparco. Each member contributes $20,000 cash in exchange for one third of Sparco's common stock. It is the only stock Sparco has outstanding.

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

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

On the first day of the second year of its operation, Sparco repays $3,000 of principal to the bank, and distributes to each shareholder, with respect to his or her stock, assets worth $4,000. The $4,000 distributions to each of Art and Brenda are in cash; the distribution to Crystal consists of some of Sparco's inventory, with a fair market value of $4,000 and a basis to Sparco immediately before the distribution of $2,500.

What are the federal income tax consequences to Art, Brenda, Crystal and Sparco 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.

Discuss.

On January 15, 1997, Ralph and Sylvia form a limited liability company, Luluco, to engage in real estate investments. Neither Luluco nor its members file any forms with the Internal Revenue Service concerning its entity classification under section 7701 of the Code.

On January 15, 1997, Ralph contributes to Luluco a parcel of land, Blackacre, that Ralph has been holding for sale to customers in his business as a real estate dealer. Blackacre has an adjusted basis in Ralph's hands of $50,000; its fair market value is $100,000, but it is encumbered by a mortgage securing a recourse loan with an outstanding principal balance of $60,000, so that Ralph's equity in the property is $40,000. Luluco assumes the mortgage liability on Blackacre, and it issues to Ralph an interest in Luluco of 80 percent of Luluco's profits and losses. Ralph's interest has a fair market value of $40,000.

Also on January 15, 1997, Sylvia receives a 20 percent interest in Luluco's profits and losses in exchange for $10,000 cash. Ralph and Sylvia agree to, and do, personally guarantee the loan, now assumed by Luluco, which is secured by Blackacre; thus, both Sylvia and Ralph are now personally liable for the debt if Luluco does not pay it.

On December 15, 1997, Luluco sells Blackacre to Percy for $45,000 cash, plus assumption of the debt encumbering it. On the sale date, the principal balance on the debt is still $60,000. For all of its other transactions during 1997, Luluco "breaks even" -- i.e., its gross income and deductions offset each other exactly.

What are the federal income tax consequences to Ralph, Sylvia and Luluco 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 LLC interest and assets held by each party, at each stage of the transactions.

Explain.