Corporate Taxation
Spring 2016
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 this set of essay questions in the original envelope in which this set came. If you are using a computer, unless you have been otherwise expressly authorized by the law school, you must submit your answers using SofTest. If you are writing answers by hand, you must write them all in the bluebook(s) you have been provided, and return the bluebook(s) along with this set of questions in the envelope.
No credit will be given for anything written on this set of questions. Only your electronic answer file or bluebook(s) will be graded.
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, assume that:
• all shareholders described in the questions are individuals;
• all shareholders and corporations described in the questions use the calendar year as their taxable year for federal income tax purposes;
• all shareholders report their income on the cash method for such purposes; and
• all corporations report their income on the accrual method for such purposes.
Any references to “the Code” are to the Internal Revenue Code of 1986, as amended.
QUESTION ONE
(One hour)
On May 1, Amy and Ben (both U.S. citizens) form a corporation, XYZ. Amy and Ben become the equal shareholders of XYZ. In the formation transaction, each shareholder receives 100 shares of common stock of XYZ and 100 shares of nonvoting preferred stock of XYZ. The common stock has a fair market value of $1,000 per share; the preferred stock has a fair market value of $500 per share. The preferred stock does not participate in corporate growth. The dividend rate on the preferred stock fluctuates annually based on the prime rate of interest charged by a commercial bank.
In the formation transaction, Amy transfers to XYZ a piece of equipment with a fair market value of $170,000 and an adjusted basis in Amy’s hands of zero. In addition to issuing common and preferred stock to Amy, XYZ assumes the liability for an account payable that Amy owes to a supplier in Amy’s business. The account payable is in the amount of $20,000. XYZ pays off the debt shortly after XYZ is formed.
Also in the formation transaction, Ben receives his XYZ stock in exchange for $60,000 cash and $90,000 worth of personal services that Ben promises to perform in connection with starting up XYZ’s business. The issuance of some of the stock in exchange for services to be rendered in the future is valid under controlling state corporate law.
What are the federal income tax consequences to Amy, Ben, and XYZ of each of the transactions just described, with and without all available elections? Be sure to discuss the amount, timing, and character (capital or ordinary) of any income, gain, loss, or deduction realized or recognized by each party; and each party's basis in the stock or assets that party holds, at each stage of the transactions.
Discuss.
(End of Question 1)
QUESTION TWO
(One hour)
Company is a C corporation with a long history of operating losses, and a deficit of $50,000 in its accumulated earnings and profits at the start of 2016. Company has only one class of stock. Company’s sole shareholder is Suri. Suri’s basis in her Company stock at the start of 2016 is $250,000.
On February 1, 2016, Company distributes to Suri Blackacre, a parcel of real property that Company has been using in its business. On the date of the distribution, and throughout 2016, Blackacre has a fair market value of $500,000, but it is encumbered by a mortgage securing a loan with an outstanding principal balance of $100,000, so that Company’s “equity” in Blackacre is $400,000. Company’s adjusted basis in Blackacre immediately before the distribution is $200,000. Suri takes Blackacre subject to the mortgage. Company makes no other distributions with respect to its stock during the year.
For 2016, not taking into account the transaction involving Blackacre, Company has gross income of $200,000 and deductions of $180,000, for taxable income of $20,000.
Answer each of the following questions:
A. (75% of question grade) What are the federal income tax consequences to Company and Suri of each of the transactions just described? Be sure to discuss the amount, timing, and character (capital or ordinary) of any income, gain, loss, or deduction realized or recognized by each party; each party's basis in the stock or assets that party holds at each stage of the transactions; and the effects of the transactions on Company’s earnings and profits.
B. (25% of question grade) How (if at all) would the federal income tax consequences to Company and Suri of each of these transactions have differed if Company had validly elected to become an S corporation effective January 1, 2016?
Explain.
(End of Question 2)
QUESTION THREE
(One hour)
Zip, a C corporation, has substantial (but reasonable) accumulated earnings and profits. Zip’s assets are highly appreciated. Zip has two classes of stock outstanding, voting common stock and nonvoting preferred stock. The preferred stock does not participate in corporate growth.
All of Zip’s outstanding common stock, 100 shares, is owned by Zip’s founder, Jill. Jill’s adjusted basis in the common stock is $1,000 per share. Jill is a salaried executive officer of Zip.
All of Zip’s preferred stock is owned by Kyle. Kyle is Jill’s elderly father. The preferred stock gives its holder the right to convert the stock into a short-term promissory note of Zip, but Kyle has never exercised this option, content to receive a sizable cash dividend each year.
Jill is approached by Perch, a large multinational corporation that wishes to purchase the Zip business. Pursuant to a three-party agreement among Jill, Zip, and Perch, the following transactions take place:
1. On March 1, Zip redeems 15 of Jill’s common shares in exchange for a five-year, subordinated promissory note in the principal amount of $150,000. Zip immediately cancels the redeemed shares.
2. On April 15, Jill transfers her remaining 85 common shares of Zip to Perch in exchange for $450,000 cash and a two-year installment note of Perch in the principal amount of $400,000. The note is secured by a pledge of the 85 shares of stock.
The three-party agreement also requires that Jill refrain from competing with Zip anywhere in its sales territory for two years commencing with the April 15 transfer. Under controlling state law, the agreement is enforceable. The agreement specifies that Jill will receive $100,000 cash at the end of each of the two years in consideration of the covenant not to compete. The cash payments are to be made by Perch. Perch also occasionally hires Jill as a consultant for a cash fee of $200 an hour.
Kyle does not participate in the transactions among Jill, Zip, and Perch. Kyle retains his Zip convertible preferred stock.
What are the federal income tax consequences to Jill, Kyle, Zip, and Perch of each of the transactions just described, with and without all available elections? Be sure to discuss the amount, timing, and character (capital or ordinary) of any income, gain, loss, or deduction realized or recognized by each party; each party's basis in the stock or assets that party holds at each stage of the transactions; and the effects of the transactions on Zip’s earnings and profits.
Discuss.
(End of examination)
Created by: bojack@lclark.edu
Update: 20 May 16
Expires: 31 Aug 17