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 partners described in the questions are individuals;

all partners and partnerships described in the questions use the calendar year as their taxable year for federal income tax purposes; and

all partners and partnerships report their income on the cash method for such purposes.

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

Amy, Beth and Carl form a limited partnership, ABC, to operate a restaurant. Amy, a restaurateur by trade, is the sole general partner. Beth and Carl, who are real estate dealers, are the limited partners.

Amy contributes a parcel of investment real estate, Blackacre, to ABC in exchange for her partnership interest. Immediately before the exchange, her basis in Blackacre is $15,000. At the time of its contribution, the property has a fair market value of $90,000, but it is encumbered by a mortgage with a principal balance of $60,000, so that Amy's "equity" in it is $30,000. The mortgage loan is a recourse loan; ABC assumes this liability as part of the exchange with Amy.

Beth contributes $30,000 cash in exchange for her limited partnership interest. For his, Carl contributes Whiteacre, a parcel of real estate he has been holding for sale to his real estate customers. Immediately before the exchange, Carl's basis in Whiteacre is $40,000; its fair market value is $30,000.

The partnership agreement specifies that all profits and losses are to be shared equally by the three partners. The agreement further specifies that partners' capital accounts shall be kept in accordance with the regulations under section 704 of the Code, and that distributions on any liquidation of ABC shall be in accordance with the partners' positive capital account balances, if any.

Upon any liquidation of ABC or of Amy's partnership interest, the agreement requires Amy to pay to the partnership in cash the amount of any negative balance in her capital account. Beth and Carl have no similar obligation to restore negative capital accounts. The agreement contains "qualified income offsets" as to Beth and Carl.

In its first year of operations, the partnership sells Whiteacre to a purchaser, Paul. Paul pays ABC $36,000 in cash for the property. Aside from the sale to Paul, ABC "breaks even" for the first year -- that is, its gross income and deductions offset each other exactly. ABC does not sell, or take any depreciation on, Blackacre.

What are the federal income tax consequences -- to Amy, Beth, Carl and ABC -- of each of the transactions just discussed? Be sure to discuss the amount, timing and character (capital or ordinary) of each item of income, deduction or loss to each party; each party's basis in the property or partnership interest which that party holds at each stage in the transactions; and ABC's balance sheet (basis, book values and capital accounts) at the end of the first year.

Discuss.

Ray and Sarah are the sole members of a limited liability company, Lilco, which owns and operates real estate. Lilco lacks continuity of life and free transferability of interests. As of January 1, 1995, each of the two members has a basis of $500,000 in his or her interest in Lilco, and a capital account of $100,000. Lilco has consistently generated about $25,000 a year of profit over the previous several years, which Ray and Sarah have split equally.

Ray and Sarah decide to have Lilco embark on an apartment development project. They plan to have Lilco build new apartments in 1995, and rent them out beginning in 1996. Ray agrees to supervise construction of the building.

On January 1, 1995, Ray and Sarah amend the operating agreement of Lilco to provide that the first $30,000 of any operating profit for 1995 is to be allocated to Ray; otherwise, profits and losses for the year will be divided equally between Ray and Sarah. (The agreement fully comports with the "big three" requirements for substantial economic effect contained in the regulations under section 704(b) of the Code.) Under the amendment, profits and losses will revert to a 50-50 split beginning in 1996.

For 1995, Lilco's operating results show a $10,000 long-term capital gain, and $40,000 of net income from investments and rental properties. The $40,000 figure includes $100,000 of ordinary income, minus $60,000 of deductions for depreciation, interest, state and local taxes, and the like, but it does not take into account any payments to members. At the end of the year, pursuant to the amended operating agreement, Lilco pays $30,000 to Ray; thereafter, Ray and Sarah have capital accounts of $110,000 each. Lilco makes no other payments or distributions to Ray or Sarah, and its outstanding debts remain constant, throughout the year.

On January 1, 1996, Lilco admits a new member, Tina. Tina agrees to provide substantial future services to Lilco in exchange for a 30 percent interest in Lilco's future profits. (Ray's and Sarah's profits interests decrease to 35 percent each.) Tina receives no immediate capital account or other capital interest.

As part of the agreement admitting her, Tina agrees to pay over to Lilco any amounts she receives from outside sources as compensation for personal services. On July 1, 1996, Tina receives from her former employer, a bank, a $10,000 check for services she rendered on behalf of the bank's equipment leasing division. Tina promptly endorses the check over to Lilco.

What are the federal income tax consequences -- to Ray, Sarah, Tina and Lilco -- of each of the transactions just discussed? Be sure to discuss the amount, timing and character (capital or ordinary) of each item of income, deduction or loss to each party, and each member's basis in his or her interest in Lilco, at each stage in the transactions.

Explain.

Ken, Lisa and Maria are partners in KLM, a partnership in which capital is a material income-producing factor. Ken has a 40 percent share of KLM's profits and losses; Lisa's and Maria's shares of profits and losses are 30 percent each. The assets of KLM are as follows:
 
 

Asset	Basis to partnership	Fair market value
Cash	$  10,000	$    10,000
Account receivable	-0-	$    40,000
Corporate stock	$   70,000	$    50,000
Total	$  80,000	$ 100,000

 
Neither the account receivable nor the corporate stock was contributed to KLM by any partner. KLM has no liabilities. Prior to the transactions discussed in this question, KLM has never made an election under section 754 of the Code. There have been no sales or exchanges of partnership interests in the last 12 months. The partners' equity in KLM is as follows:
 
 

Partner	Basis of partnership interest	Fair market value
Ken	$    32,000	$    40,000
Lisa	$    24,000	$    30,000
Maria	$    24,000	$    30,000
Total	$ 80,000	$ 100,000

Ken wishes to leave the partnership completely. Two alternatives are under discussion:

A. In a distribution that liquidates Ken's interest, KLM distributes the account receivable to Ken.

B. Ken sells his partnership interest to a new partner, Nuguy, for $40,000 cash.

What are the federal income tax consequences -- to Ken, Lisa, Maria, Nuguy and KLM -- of each of these alternatives, with and without any available elections? Be sure to discuss the amount, timing and character (capital or ordinary) of each item of income, deduction or loss to each party; each party's basis in the property or partnership interest which that party holds (actually or constructively) at each stage in the transactions; and KLM's balance sheet (basis and fair market values) immediately after each alternative.

Discuss.