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;

-- all shareholders and corporations described in the questions use the calendar year as their taxable year for federal income tax purposes;

-- all shareholders and S corporations report their income on the cash method for such purposes; and

-- all C corporations report their income on the accrual method for such purposes.
 
 

On May 1, 1995, Greg, Hilary and Iris form a corporation, Korp, to engage actively in a real estate-related business. Korp has only one class of stock, voting common stock.

In the incorporation, Greg receives 20 shares of Korp stock in exchange for his personal services, to be performed on a regular basis as part of the corporation's routine business over the remainder of 1995; such services are permissible consideration for the stock under applicable state law. At the same time, Greg purchases 20 additional Korp shares for $20,000 cash.

Also in the incorporation, Hilary receives 20 Korp shares in exchange for Hillacre, a parcel of real estate that she has been holding for sale to customers in her real estate business. Immediately before the exchange, Hilary's adjusted basis in Hillacre is $10,000; its fair market value is $55,000; and it is encumbered by a first mortgage with an outstanding balance of $35,000, so that Hilary's "equity" in it immediately before the exchange is $20,000. Korp assumes the mortgage on Hillacre.

In her part of the transaction, Iris transfers to Korp an account receivable that she earned for her services as a real estate consultant. Her adjusted basis in the receivable immediately before the transfer is zero; its fair market value is the same as its face value, $20,000. Iris receives 20 shares of Korp stock in the exchange.

For the period beginning with the incorporation and ending on December 31, 1995, Korp enters into only a few transactions. It begins business on July 1. On July 10 it collects from Iris's former client the full $20,000 on the receivable. Later in July, it uses $20,000 cash to buy stock as an investment. In October, it sells that stock for $28,000 cash. Over the entire period ending December 31, 1995, Korp's only expenses (other than the stock issued to Greg) are $2,000 of legal fees, which it paid for having articles of incorporation, bylaws, and minutes of initial directors' and shareholders' meetings drafted. Korp makes no distributions to its shareholders with respect to its stock in 1995.

Korp makes a valid election on May 1 to be taxed as an S corporation for its first taxable year ending December 31, 1995.

What are the federal income tax consequences -- to Greg, Hilary, Iris and Korp -- of the transactions described above? Be sure to discuss the amount, timing and character (capital or ordinary) of each item of income, loss, deduction or credit; the basis of the stock and assets held by each party; and Korp's earnings and profits (if any), at each stage in the transactions.
 

Discuss.
 
 

Pelico, a C corporation, has two shareholders, Sara and Ted. Other than being fellow shareholders, these two individuals are unrelated to each other. On May 1, 1995, Sara owns 5,000 shares of Pelico's voting common stock, with a basis to her of $30 per share (for a total stock basis of $150,000) and Ted owns the other 5,000 shares of voting common, with a basis to him of $30 per share (for a total stock basis of $150,000). Sara has an option to purchase 3,000 of Ted's shares at any time through 1999.

Pelico has only one class of shares outstanding on May 1. As of that date, and throughout 1995 and 1996, its current and accumulated earnings and profits exceed $650,000. (The accumulation is reasonable for the needs of Pelico's business.)

On June 1, 1995, Pelico declares and distributes a stock dividend. Each holder of a share of its outstanding common stock receives one share of a new class of Pelico stock, nonvoting preferred stock, which is limited as to dividends and liquidation rights. Each share of preferred has a fair market value at the time of the stock dividend of $25. Immediately after the stock dividend, each share of common stock has a fair market value of $50. Thus, on June 2, 1995, the actual share ownership of Pelico and the fair market value of the various shares are as follows:
 

Shareholder	Number of Common Shares	Common F.M.V	Number of Pref'd Shares	Pref'd F.M.V.	Total F.M.V.
Sara	5,000	$250,000	5,000	$125,000	$375,000
Ted	5,000	$250,000	5,000	$125,000	$375,000

On December 1, 1995, Ted sells his 5,000 shares of Pelico preferred stock to a speculator for $125,000 cash.

On January 1, 1996, following the sale of some unwanted business assets, Pelico redeems 2,000 shares of Sara's common stock for $100,000 cash. On July 1, 1996, Pelico redeems another 1,000 shares of common stock from Sara for $50,000 cash. Finally, on December 1, 1996, Pelico redeems another 1,000 shares of common stock from Sara for $50,000 cash.

What are the federal income tax consequences to Sara and Ted of each of the transactions described above? Be sure to discuss the amount, timing and character (capital or ordinary) of each item of income, deduction, loss or credit, and each shareholder's basis in his or her various shares of stock, at each stage of the transactions.

Explain.

Donna and Eddie, U.S. citizens, are long-time shareholders of a C corporation, Ceecorp, which is engaged in wholesaling and investment. Donna owns 70 percent of Ceecorp's single class of stock, common stock; her shares have a total basis of $300,000. Eddie, who is unrelated to Donna (except for being her fellow shareholder of Ceecorp), owns the other 30 percent of Ceecorp's stock; his shares have a total basis of $200,000.

Ceecorp owns the following assets with the following adjusted bases and fair market values:
 

Asset	Adjusted basis	Fair market value
Cash	$ 50,000	$ 50,000
Inventory	$ 275,000	$ 450,000
Goodacre	$ 30,000	$ 200,000
Badacre	$ 400,000	$ 300,000
Total	$ 755,000	$1,000,000

Ceecorp purchased Goodacre and Badacre, each of which are parcels of real estate, as investments several years ago; it bought the inventory within the last year. Ceecorp has no debts. Its accumulated earnings and profits at the beginning of this year were $250,000; it expects additional earnings and profits in the current year.

To avoid double taxation of Ceecorp's future profits, Ceecorp's accountant, Murray, has suggested that Ceecorp be converted to a limited liability company (LLC). Murray proposes that Ceecorp liquidate, distributing the cash, the inventory, and Goodacre to Donna, and distributing Badacre to Eddie.

Under this proposal, in a second step, Donna and Eddie would transfer all of the assets they have received from Ceecorp to a new LLC, in exchange for membership interests in the LLC. As with Ceecorp, Donna would own 70 percent of the interests in the LLC, and Eddie would own the other 30 percent.

Assume that:

-- the second step in Murray's proposal -- formation of the LLC -- will not be a taxable event for Donna, Eddie or the LLC; and

-- formation of the LLC does not make the federal tax consequences of the proposed liquidation of Ceecorp any different from those of a corporate liquidation that is not followed by such a transaction.

Donna and Eddie expect Ceecorp (or the successor LLC) to show modest profits for each of the next few years. They want Ceecorp (or the successor LLC) to begin making sizeable distributions to them as owners in the near future. Donna is also considering withdrawing Goodacre or Badacre from the joint enterprise within a few years and owning it in her own name.

Answer each of the following questions:

A. What would the federal income tax consequences be -- to Donna, Eddie and Ceecorp -- of the proposed liquidation of Ceecorp? Be sure to discuss the amount, timing and character (capital or ordinary) of any income, deduction, loss or credit to each party; Donna's and Eddie's basis in each asset he or she receives in the liquidation; and the impact (if any) of Ceecorp's earnings and profits. (Do not discuss the tax consequences of the formation of the LLC.)

B. What will the federal income tax results be in future years if, instead of liquidating Ceecorp and forming an LLC, Donna and Eddie simply have Ceecorp elect to be taxed as an S corporation, and events otherwise go as they foresee them?

Discuss.

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