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 both this set of essay questions and your answers in the original envelope in which this set came.

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.
 
 

In 1997, Reba, Sid and Terry form a limited liability company, RST. Neither RST nor its members file any forms with the Internal Revenue Service concerning its entity classification under section 7701 of the Code.

Reba contributes $300,000 cash in exchange for her interest in RST. For his interest in RST, Sid contributes land, Blackacre, with a basis to him of $360,000 and a fair market value of $360,000, subject to a recourse mortgage of $60,000. For her interest in RST, Terry contributes a building, Whiteacre, with a basis to her of $60,000 and a fair market value of $300,000. Whiteacre is situated on leased land, and its entire basis is depreciable.

The LLC's operating agreement provides that all profits and losses of RST are to be shared equally among the members. The agreement complies with the regulations under section 704 of the Code. Reba, Sid and Terry are required to restore any negative balances in their capital accounts upon liquidation of RST.

RST assumes the liability on Blackacre, and Reba, Sid and Terry jointly and severally guarantee RST's obligation to the lender. For several years immediately following the formation of RST, the debt calls for payments of interest only.

At the time of the contribution of Whiteacre, its remaining life for depreciation purposes is 20 years. Depreciation is to be taken on a straight-line basis over the 20-year period. Assume that a newly acquired building of the same type would be depreciable on a straight-line basis over a 40-year period. Assume further that no depreciation convention (e..g., half-year, mid-quarter or mid-month) is applicable to any building, including Whiteacre.

Answer each of the following questions:

A. What are the federal income tax consequences -- to Reba, Sid, Terry and RST -- of each of the exchanges by which RST was formed? 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 LLC interest which that party holds at each stage in the transactions; and RST's balance sheet (basis, book values and capital accounts) immediately after the exchanges.

B. How are the depreciation deductions on Whiteacre to be allocated among Reba, Sid and Terry under all available options?

Discuss.

Gary and Laura are planning to form a limited partnership in 1997. Gary will be the general partner and Laura the limited partner. Gary will contribute $100,000 cash in exchange for his interest in the partnership, and Laura will contribute $400,000 cash in exchange for hers. Because of Gary's work as a general partner, the profits from the partnership are to be shared equally by Gary and Laura.

The partnership is planning to borrow an additional $2,000,000 of capital on a nonrecourse basis and to construct a building on leased land at a cost of $2,500,000. The building will be the sole collateral for the nonrecourse mortgage. Assume that the depreciation on the building will be $100,000 a year for 25 years. Assume further that no depreciation convention (e..g., half-year, mid-quarter or mid-month) is applicable to the building.

Laura is unwilling to commit to making any further investment in the partnership beyond her $400,000 initial contribution.

Gary and Laura wish to allocate $80,000 a year of the depreciation on the building to Laura, with the other $20,000 a year being allocated to Gary, for the entire 25-year depreciation period. May they do so? What types of provisions might they include in the limited partnership agreement to help achieve this result? How will the mortgage be allocated under section 752 of the Code over the depreciation period for the building?

Explain.

Karla, Lou and Merle are partners in KLM, a partnership in which capital is a material income-producing factor. Karla has a 50 percent share of KLM's profits and losses; Lou's and Merle's shares of profits and losses are 25 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
Inventory	45,000	50,000
Total	$ 55,000	$ 100,000

Neither the account receivable nor the inventory 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. The partners' equity in KLM is as follows:
 
 

Partner	Basis of partnership interest	Fair market value
Karla	$ 27,500	$    50,000
Lou	13,750	25,000
Merle	13,750	25,000
Total	$ 55,000	$ 100,000

Lou, who has been quite active in the day-to-day operations of KLM, now wishes to retire from the partnership. In 1997, KLM distributes $1,500 cash, $10,000 worth of receivables and $15,000 worth of inventory to Lou in liquidation of his interest.

What are the federal income tax consequences -- to Karla, Lou, Merle and KLM -- of this transaction, 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 of the actual or deemed transactions; and KLM's balance sheet (basis and fair market values) immediately thereafter.

Discuss.