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, 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 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.
 
 

Comco is a corporation with only one class of stock (voting common stock). There are 100 shares of Comco stock outstanding: 40 held by Wilma; 40 held by Wilma's husband, Henry; and 20 owned by a C corporation, Prodco. Prodco has two shareholders, each of whom own exactly one half of the Prodco stock -- Henry (the same person as the shareholder of Comco) and George, Wilma's maternal grandfather.

Wilma's basis in her shares of Comco is $40,000, or $1,000 per share. Henry's basis in his Comco stock is also $1,000 a share, for a total stock basis for Henry in Comco of $40,000. Prodco's basis in the Comco shares it owns is much higher. Its total basis is $300,000, or $15,000 per Comco share.

At the beginning of 1990, the Comco shares have a fair market value of $15,000 per share. The total net worth of Comco at the beginning of 1990 is $1,500,000.

Comco's accumulated earnings and profits as of the end of 1989 is $1,000,000. Assume that for the full year 1990, Comco's earnings and profits, not taking into account any distributions in that year, are a negative $200,000. The deficit is caused by an operating loss incurred in Comco's business operations.

In January of 1990, Comco sells all of the stock of Comco's major operating subsidiary, Subco, to Predco, an unrelated takeover specialist, for $900,000 cash. For many years prior to the sale, Comco and Subco have each been engaged in the active conduct of a trade or business. The shareholders of Comco want to withdraw the proceeds of the Subco sale from Comco in the near future. They come to you, a tax lawyer, in late 1990 for tax advice on the following two alternative plans for distributing the funds:

A. In December 1990, Comco redeems 20 of its shares from Wilma in exchange for $300,000 cash, and Henry's 40 shares in exchange for a short-term promissory note (payable, along with interest, in 1990 and 1991) with a face amount of $600,000 and a fair market value of $500,000.

B. In December 1990, Comco redeems Prodco's 20 Comco shares for $300,000 cash, and Henry's 40 shares for a short-term note as described in Plan A above.

Write a memorandum explaining the federal income tax consequences to Wilma, Henry and Prodco of each of the two distribution plans just outlined. Be sure to discuss the amount and timing of any income, gain, loss or deduction to each shareholder; the effect of the transactions on the shareholders' stock basis; and the effect of the transactions on the earnings and profits of the corporations.

Explain.

Sarah owns all of the stock of Tesco, a C corporation with large current and accumulated earnings and profits. Sarah's basis in her stock of Tesco is $100,000. The aggregate fair market value of Tesco's assets is $1,000,000; its aggregate basis in these assets is $350,000; and it has liabilities of $250,000 (all guaranteed by Sarah). The fair market value of the Tesco stock is $750,000.

Sarah is approached by Buxco, a large corporation with great resources. Buxco wants to acquire Tesco's business and, with the financial backing of foreign investors, turn it into worldwide enterprise. Buxco proposes to acquire the Tesco business under two alternative plans:

A. Tesco liquidates, distributing all of its assets to Sarah; Buxco purchases the former Tesco assets from Sarah for $750,000 cash plus assumption of all of the former Tesco liabilities.

B. Buxco purchases all of the assets of Tesco from Tesco for $750,000 cash plus assumption of the Tesco liabilities; Tesco liquidates, distributing the cash to Sarah.

Answer each of the following questions:

(i) What are the federal income tax consequences to Tesco, Sarah and Buxco of the two plans Buxco has proposed? 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 property that party holds, at each stage of the transactions proposed.

(ii) How would your answer to Part (i) have been different if Tesco had been an S corporation ever since its formation in 1984? Again, be sure to discuss the amount and timing of any income, gain, loss or deduction to Tesco, Sarah and Buxco, and each party's basis in any stock or property that party holds, at each stage of the transactions proposed.

Discuss.

Kincorp is a C corporation formed several years ago. Ever since shortly after it was incorporated, Adrian has held 75 shares of Kincorp's common stock, and Beth has held the other 25 shares. As of June 1, 1990, there are no other shares of stock outstanding. The stock has a fair market value of $3,000 a share.

As of June 1, 1990, Kincorp's assets consist of $100,000 cash; Blackacre, with an adjusted basis of $50,000 and a fair market value of $110,000; and equipment with a fair market value of $90,000. As of that date, Kincorp has no debt of any significance, as it pays all its bills when due and has no loans outstanding. Kincorp's accumulated earnings and profits are $100,000; it has (and will have) no current earnings and profits in 1990.

On June 15, 1990, Beth transfers $100,000 cash to Kincorp in exchange for the corporation's 10-year debenture. The debenture bears interest at the rate of 8 percent simple interest; it calls for level payments of principal and interest over the 10-year term. (The annual payments called for come to about $15,000 a year.) At the time the debenture is issued, the going rate among local banks for 10-year loans to large corporations is 9 percent.

By its terms, the debenture will be subordinated to the first $500,000 of debt (if any) that Kincorp incurs on borrowings from outside creditors in the future. The debenture is convertible to additional common stock over the next five years at Beth's option, so long as she has been the holder of the debenture during that period.

On August 1, 1990, Adrian transfers inventory to Kincorp. Immediately prior to the transfer, Adrian's basis in the inventory is $150,000; the inventory has a fair market value of $210,000. In exchange for the inventory, Kincorp transfers to Adrian 33 shares of additional common stock, with a fair market value of $100,000, plus Blackacre.

Immediately after the exchange, Adrian owns 108 shares of common stock out of 133 now outstanding; Beth continues to own 25 shares. By virtue of the exchange, Adrian's percentage ownership of the common stock increases from 75 percent to 81.2 percent.

Answer each of the following questions:

(i) Does the exchange between Adrian and Kincorp qualify as a transaction described in Section 351(a) of the Internal Revenue Code of 1986, as amended?

(ii) Assuming that the exchange between Adrian and Kincorp does qualify under Section 351(a), what are the federal income tax consequences of the exchange to Adrian and Kincorp? Be sure to explain the amount and timing of any income, gain, loss or deduction to each taxpayer; Adrian's basis in the stock and in Blackacre immediately after the exchange; Kincorp's basis in the inventory; and the effect of the transaction on Kincorp's earnings and profits.

(iii) When Kincorp makes the first $15,000 annual payment on the debenture to Beth, what are the federal income tax consequences to Beth?

Explain.
 

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