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, your answers to these essay questions will be collected. This set of questions will not be collected, and no credit will be given for anything written on it.

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 shareholders described in the questions are individuals; that all shareholders and corporations described in the questions report their income on the calendar year for federal income tax purposes; that all shareholders report their income on the cash method for such purposes; and that all corporations report their income on the accrual method for such purposes.
 
 

A tax lawyer, you represent a C corporation named Norco. Norco has one class of stock, common stock, with 10,000 shares outstanding. Gwen owns 5,000 shares; her twin sister, Cindy, owns the other 5,000 shares. Each share of the stock held by each shareholder has a basis of $50.

Norco's accumulated earnings and profits are huge -- about $1,000,000 -- and they have been that way for some time, as Norco has always been profitable and has paid no dividends. Norco's operations for the current year (1989) also produce a profit, and thus current earnings and profits. Its common stock is worth $100 per share; Norco's total net worth is $1,000,000.

On January 1, 1989, Norco declares and immediately distributes a stock dividend. The holder of each share of its common stock receives one share of nonvoting preferred stock. The preferred stock has a value of $40 per share, or a total of $400,000; after the stock dividend, the common stock's value declines to $60 per share, or a total of $600,000.

Ten months later, on November 1, 1989, Norco's assets are as follows:
 

Asset	Basis	Fair market value
Cash	$600,000	$600,000
Account receivable	$350,000	$350,000
Equipment	$ 10,000	$200,000
Real estate used in business	$400,000	$800,000
Inventory	$140,000	$100,000
Goodwill	-0-	$ 50,000
Total	$1,500,000	$2,100,000

Norco's only liability is a bank debt of $1,100,000.

On November 1, 1989, in a transaction completely unrelated to the stock dividend, Norco is approached by another C corporation, Acquisico, which wants to acquire some, but not all, of Norco's business assets for use in Acquisico's own business. Acquisico wants to acquire the equipment and inventory for a total price of $300,000. Coincidentally, Cindy needs $300,000 cash so that she can invest in a real estate development project.

Acquisico proposes the following two transaction formats:

1. Acquisico buys the inventory and equipment from Norco for a total of $300,000 cash; Norco distributes the $300,000 to Cindy in exchange for all 5,000 shares of her preferred stock (worth a total of $200,000) and 1,667 shares of her common stock (worth a total of $100,000).

2. Acquisico buys all of Cindy's preferred stock from her for $200,000, and 1,667 shares of her common stock for $100,000; Norco distributes the inventory and equipment to Acquisico in redemption of Cindy's old Norco pre-ferred stock and the 1,667 shares of Norco common stock.

Under either format, immediately following the exchange, Cindy will actually own none of the Norco preferred stock and just slightly less than 40 percent (3,333/8,333) of the outstanding Norco common stock; Gwen will actually own all of the Norco preferred and just slightly more than 60 percent (5,000/8,333) of the Norco common.

Answer of the following questions:

A. What are the federal income tax consequences to Gwen and Cindy of the stock dividend? What is the basis of the common and preferred stock that each of them hold immediately after the stock dividend?

B. What are the federal income tax consequences to Cindy, Norco and Acquisico of each of the two proposed formats for the acquisition transaction? Be sure to discuss the amount and timing of each party's gain and loss -- and the basis of the Norco stock, the inventory and the equipment in each party's hands -- at each stage of the transactions.

Discuss.

Xavier, Yolanda and Zeke have decided to form a new corporation, Tesco. Xavier and Yolanda are artists who live and work in New York City. Zeke, a wealthy financier, is not a U.S. citizen; he is a resident of Switzerland.

The three present you the following proposal:

1. Tesco will be incorporated in the United States. It will have two classes of stock, voting common and nonvoting preferred. Tesco will adopt the cash method of accounting for tax and financial accounting purposes.

2. Xavier will transfer to Tesco real estate with an adjusted basis to Xavier of $28,000 and a fair market value of $100,000. The property is subject to a longstanding mortgage with an outstanding principal balance of $20,000, so that Xavier's "equity" in the property immediately before the exchange is $80,000. Tesco will take the property subject to the mortgage. In exchange for the property, Tesco will issue to Xavier 80 shares of its common stock and 80 shares of its preferred stock.

3. Yolanda will transfer to Tesco an account receivable, with an adjusted basis to her of $500 and a face amount and fair market value of $1,000. In exchange for the account, Tesco will issue to Yolanda one share of its common stock and one share of its preferred stock. In addition, in exchange for Yolanda's past services in organizing the corporation, Tesco will issue to her nine shares of its common stock and nine shares of its preferred stock. (Assume that the services are valid consideration for the stock under state law, and that one share of common and one share of preferred together are worth a total of $1,000.)

4. Zeke will transfer $40,000 cash to Tesco; in exchange, Tesco will issue to Zeke 10 shares of its common stock, 10 shares of its preferred stock, and a 20-year interest-bearing bond (which is truly a debt for tax purposes) with a face amount and fair market value of $30,000. The bond bears interest at a market rate, and the interest is payable monthly.

5. A few months after Tesco is formed, Xavier will sell Zeke 50 shares of Tesco common stock and 50 shares of Tesco preferred stock for a total of $50,000 cash.

Assume that you have adequately disclosed your actual and potential conflicts of interest, and that all parties have knowingly consented to your representing all of them.

Answer each of the following questions:

A. What are the federal income tax consequences to each of the three shareholders, and to Tesco, of all the actions described in the proposal? Be sure to discuss the amount and timing of any income, gain, loss or deduction to each shareholder and to the corporation; and the basis of any stock, debt or other property held by each of these four parties at each stage in the transactions.

B. Is Tesco eligible to make an election to be taxed under Subchapter S? Why or why not?

Explain.

Oldco is a C corporation formed many years ago. It has large accumulated earnings and profits. Oldco's sole shareholder is Sid. Sid's basis in his Oldco stock is $70,000. Sid is ready to retire and wants to transfer the Oldco business to a publicly traded C corporation, Pubco.

Oldco has two principal assets, Redacre and Whiteacre. Redacre's fair market value is $100,000 and its adjusted basis is $200,000. Oldco acquired Redacre from Sid about a year ago in a transaction described in Section 351 of the Internal Revenue Code; at the time of that transaction, the fair market value of Redacre was $140,000 and its adjusted basis was $200,000.

Whiteacre has a fair market value of $100,000 and an adjusted basis of $30,000; Oldco purchased it many years ago. The property is subject to a mortgage with an outstanding principal balance of $40,000, so that Oldco's "equity" in the property is $60,000. (Oldco has no other debts.)

Oldco also owns a sizeable quantity of supplies that it has stored up for future use in its business. It properly deducted the cost of these supplies as an ordinary and necessary business expense as soon as it acquired them. The original cost and current fair market value of these items is $10,000.

For various nontax reasons, Sid and Pubco have agreed that Pubco will acquire the Oldco business under one of the following two acquisition plans:

1. Oldco liquidates, distributing Redacre, Whiteacre and the supplies to Sid; Sid takes Whiteacre subject to the mortgage; Sid then sells Redacre, Whiteacre and the supplies to Pubco for $170,000 cash, with Pubco also assuming the mortgage on Whiteacre.

2. Sid transfers all of his Oldco stock to Pubco in exchange for Pubco voting stock worth $165,000 plus $5,000 cash, either in a statutory merger or in an exchange which is neither a statutory merger nor a consolidation; Pubco operates Oldco as its subsidiary.

What are the federal tax consequences to Sid, Oldco and Pubco of the transactions described in each of these plans? Be sure to discuss the amount and timing of any income, gain, loss or deduction to each party, and each party's basis in any stock or other property held by that party, at each stage in the transactions.

Discuss.

Created by:  bojack@lclark.edu
Update: 07 Mar 02
Expires: 31 Aug 02