WILLIAM MITCHELL COLLEGE OF LAW

FINAL EXAMINATION--TAKE-HOME

BUSINESS ENTITY TAX

SPRING 1997

Professor DENISE ROY

Handout Date: Monday, May 5, 1997, 8:30 a.m.

Due Date: Wednesday, May 14, 1997, 9:00 p.m.

ADDITIONAL INSTRUCTIONS:

1. ONCE YOU HAVE PICKED UP THIS EXAM, YOU MAY DISCUSS THE EXAM WITH OTHER MEMBERS OF THE CLASS. DO NOT DISCUSS THE EXAM, THE ISSUES RAISED IN THE COURSE OR ANY OTHER ASPECT OF THE COURSE WITH ANY PERSON OTHER THAN MEMBERS OF THE CLASS AND ME. YOU MUST WRITE YOUR OWN EXAM ANSWERS, INCLUDING DIAGRAMS.

2. You may use the textbook and Internal Revenue Code volume assigned for the course, your own notes and outlines and any course handouts. You may not consult any outside materials.

3. This examination must be typewritten or printed (not handwritten) and is subject to a 15-page length limitation. In addition, each section of the exam is subject to the page limitation specified on the exam. Any required diagrams must be provided on separate sheets of paper that will not be counted for purposes of the applying the page limitation(s). IF YOU EXCEED THE PAGE LIMITATION(S), YOU WILL BE GRADED ONLY ON THE PAGES THAT FALL WITHIN THE LIMITATION (E.G., ON THE FIRST 15 PAGES). Answers must be doubled spaced on 8-1/2 x 11 inch paper with non-proportional-type font ⁽¹⁾ having no more than 12 characters per inch (CPI) ⁽²⁾ and normal top and bottom 1 inch margins and left and right 1 inch margins. Do not justify the right-hand margin of your text. Type only on one side of each sheet of paper. Do not use footnotes. PLACE YOUR TEST NUMBER ON EACH PAGE OF YOUR ANSWER AND NUMBER YOUR PAGES. FAILURE TO COMPLY WITH THESE INSTRUCTIONS MAY BE TAKEN INTO ACCOUNT IN YOUR GRADE.

4. You will be graded on the quality of your analysis rather than on the conclusions you reach. Do not discuss extraneous issues. Limit your analysis to federal income tax issues. Do not discuss other tax (e.g., payroll, estate and gift, state) issues that may be presented by the questions

5. You may assume that (1) corporations are Subchapter C corporations, (2) gains from the disposition of property are capital gains, and (3) taxpayers use the cash method of accounting, unless the question specifically states otherwise.

6. You need not provide numerical answers but may do so if you choose. In some cases you may not have sufficient information to provide numerical answers. If you do provide numerical answers, be sure to explain how you reached your conclusions.

Good luck on your exam. It has been a pleasure working with you this semester.

I (20%)

Write no more than 2 pages total (not including diagrams) on the questions in this section.

Your client, Cliff, wants to liquidate his substantially appreciated limited partnership interest with minimal tax cost. He has heard that a partner can withdraw from a partnership tax-free if he takes property, rather than cash, from the partnership in consideration for his partnership interest. Unfortunately, the partnership has cash reserves available to pay Cliff but has no property that it can spare or that Cliff wants. Cliff wants to know whether "it would work" from a tax standpoint if the partnership used its cash to purchase property desirable to Cliff and then distributed that property to Cliff in complete liquidation of his partnership interest.

In a brief, pre-heavy-duty-research meeting with Cliff about this situation, discuss in general, client-friendly terms whether the transaction he is proposing will give him the nonrecognition consequences he would like. In connection with this discussion, consider the following questions and instructions, as well as any other relevant consideration: What limitations on tax-free treatment should you point out to Cliff? What suggestions could you make for structuring the transaction to increase the chances of nonrecognition treatment for Cliff? Make note of any information you need about Cliff's partnership interest, the partnership and the proposed transaction to assist in determining whether it will be possible to structure a liquidating distribution of property along the lines Cliff is suggesting as a nonrecognition event.

II (40%)

Write no more than 3 pages total on the questions in this section.

The S & S Shipping Corporation ("S & S") was formed as a "C" corporation in 1982 by Stephie and Steve, who are married to each other. They have remained the sole owners of the business. S & S has been extremely successful and has generated a large amount of accumulated (and mostly undistributed) earnings and profits. In 1992, Stephie and Steve's daughter, Gigi, began working as a lowly scheduler for S & S. Her parents hoped she would eventually take over the business, allowing them to retire. Happily, Gigi's singleminded devotion to profitability ("show me the money") and talent as a manager propelled a rapid ascent through the corporate ranks. Today, Gigi is S & S's vice president in charge of domestic operations.

Stephie and Steve would like to retire from the S & S business. Stephie will form a transportation consulting firm after leaving S & S and hopes to be hired by S & S to analyze the possibility of providing guaranteed overnight delivery of goods. S & S's accountant has made the following proposal:

(1) Stephie and Steve will make a gift to Gigi of 20 percent (100 shares) of the total outstanding stock of S & S;

(2) S & S will redeem Stephie and Steve's remaining 400 shares of stock for $100,000 plus a $400,000 S & S promissory note paying interest of 15 percent. The note will be payable monthly over a 20-year term and will be secured by an interest in the corporation's assets. Additionally, the corporation will agree to restrict dividend payments, limit new indebtedness, and refrain from taking certain extraordinary corporate actions (like a merger or liquidation) during the term of the note.

Explain the federal income tax consequences to Stephie and Steve from the accountant's proposal.

III (60%)

Write no more than 10 pages total (not including diagrams) on the questions in this section.

Anna, Ben and Carol each operate separate novelty manufacturing businesses as sole proprietors. They want to combine their operations into a single business, Abracadabra, which will operate either as an S corporation or as a general partnership. In Year 1, each owner will contribute $30,000 (net fair market value) in cash or property, and each will have a one-third interest in the combined business. Anna will contribute $30,000 in cash. Ben will contribute equipment worth $39,000, subject to a $9,000 recourse debt, in which Ben has adjusted basis of $10,000. (You may assume that Ben's built-in gain is entirely attributable to depreciation and therefore is subject to recapture when recognized at the applicable ordinary income tax rate.) Carol will contribute real property worth $45,000 in which she has adjusted basis of $21,000. Carol will receive from the business $15,000 in cash in addition to her ownership interest. Ben and Carol have held the property they will contribute for longer than one year. Please analyse the tax consequences to the parties from these contributions in formation of Abracadabra as directed below. In addition to addressing the standard set of tax consequences, include information about (1) gains and losses realized by Anna, Ben and Carol from the contributions of property to the business, (2) the effect of the transfers on the owners' capital accounts (where relevant), and (3) the amount of built-in gains and losses in Anna, Ben and Carol's ownership interests, as well as in assets of the business, immediately following the formation transaction.

(a) Diagram the formation transaction described above.

(b) Assume Abracadabra is formed as an S corporation.

(1) Analyze the tax consequences to Anna, Ben, Carol and Abracadabra of the above exchanges in formation of Abracadabra.

(2) How does your analysis in (1), above, change if Ben contributes property worth $48,000, subject to a debt of $18,000, with adjusted basis of $10,000?

(3) What effect would Anna's receipt of one-third of the Abracadabra stock in exchange for her agreement to serve as plant manager have on your analysis of the property exchanges in (1), above? For purposes of this question, assume that (i) Anna does not contribute any cash to Abracadabra; and (ii) Carol receives from the business $15,000 of the equipment, but none of the associated debt, contributed by Ben (rather than $15,000 cash) in addition to her one-third stock interest. State your answer in three sentences or less and avoid using numbers in your answer; use concepts instead.

(4) Analyze the tax consequences to the parties if Abracadabra has net operating income of $120,000 in Year 2, a net operating loss of $150,000 in Year 3 and sells the real property contributed by Carol for $100,000 in Year 4. Assume Abracadabra's adjusted basis in the real property does not change from the time of contribution to the time of sale.

(c) Assume Abracadabra is formed as a general partnership.

(1) Analyze the tax consequences to Anna, Ben, Carol and Abracadabra of the exchanges in formation of Abracadabra. Analyze the transfer of boot to Carol as a partial sale of her real property.

(2) How does your analysis in (1), above, change if Ben contributes property worth $48,000, subject to a debt of $18,000, with adjusted basis of $10,000?

(3) How does you analysis of Anna's tax consequences in (b), above, change if she does not contribute any cash but instead agrees to serve as plant manager in exchange for a one-third profits interest? For purposes of this question, you may assume that (1) Anna will have an initial capital account balance of $0 before taking into account the effect of the debt, (2) Ben and Carol will each have an initial capital account balance of $30,000 before taking into account the effect of the debt; (3) each owner will be allocated one-third of the partnerhip's tax items, including income, gain, deductions, losses and credits; and (4) Carol receives from the business $15,000 of the equipment, but none of the associated debt, contributed by Ben (rather than $15,000 cash) in addition to her one-third ownership interest.

(5) If Carol receives boot in the form of $15,000 of Ben's equipment (rather than cash), what additional issues need to be considered in your analysis in (b)(1), above? Please list the issues and do not analyze them.

(6) Analyze the tax consequences to the parties if Abracadabra has net operating income of $120,000 in Year 2, a net operating loss of $150,000 in Year 3 and sells the real property contributed by Carol for $100,000 in Year 4. Assume Abracadabra's adjusted basis in the real property does not change from the time of contribution to the time of sale.

(d) Taking into account what you have learned in conducting your analysis, would you recommend that Abracadabra be formed as an S corporation or as a general partnership, assuming that minimizing tax costs is the sole criterion for making that choice? Explain.

THE END

1.

⁰ Nonproportional fonts, such as Courier, have letters that are all the same size. Therefore, the number of characters per inch does not vary depending on the letters used.

2.

⁰ CPI is not the same as "point" size (e.g., 10-point font). The exam questions appear in Courier font size 10, which meets the 12 CPI requirement. Use a ruler or compare with the exam questions to make sure you get the font size correct.