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INSTRUCTIONS Unless expressly provided to the contrary, all references to limited liability companies, or LLCs, refer to LLCs that have not elected C corporation or S corporation tax treatment. All references to “Code” refer to the Internal Revenue Code of 1986, as amended. When we refer to “equity,” we mean the asset representing ownership in the venture or entity in the hands of the owner, such as stock in a corporation or a membership interest in an LLC. So for instance, in the case of a corporation, a sale of equity would be a sale by the stockholders of their stock. This should be contrasted with an asset sale, which would mean, in the case of a corporation, a sale by the corporation of its assets followed by a liquidation of the corporation in cancelation of its outstanding shares of stock. When we ask about tax consequences, you will receive full credit for discussing federal taxes only and not addressing state or local taxes. In completing the exam, feel free to use the course outline as well as any research materials or sources, whether written or on line, but please do not talk to each other or to anyone else about the exam. Should you feel a question is ambiguous, please explain the ambiguity and answer the questions as well as you can. Good luck. QUESTION ONE You are planning to meet with three (3) new individual clients (which we will sometimes refer to as the “Clients” throughout this Exam), Betty, Bertha, and Bonnie, in order to advise them what type of entity to form for their new business of the manufacturing and sale of popcorn (which we will sometimes refer to as the “Business” throughout this Exam). At the meeting, what questions would you ask and, in the case of each question, why is the information relevant? QUESTION TWO In connection with the Business, Betty is willing to contribute a building with an adjusted basis to Betty of $2,000 and a fair market value of $2,000,000; Bertha is willing to contribute cash of $2,000,000; and Bonnie has agreed to provide the service of popping the popcorn for three (3) years. (a) The Clients want any future growth in the value of the Business to be shared equally between the three of them, but that none of them be subject to any income tax upon formation of the entity and issuance of equity in the entity to any of them. (i) (ii) (iii) The Clients, who like to keep things simple, suggest they form a C corporation, with a single class of common stock, and that they each be issued an equal amount of shares for their respective contributions mentioned above. What would you advise the Clients are the potential drawbacks of this plan? What might you suggest as an alternative plan and why? In your response, please consider solutions for each an S corporation, a C corporation and an LLC. (b) Betty’s building is subject to a mortgage of $1,000,000 for which Betty is personally liable. Please propose a structure pursuant to which Betty will not recognize any gain on contribution of the building for one third of the common equity of the new entity. Can this goal be accomplished if the entity is a corporation? Why or why not? If Bonnie unexpectedly inherits $2,000,000 and is able to contribute this cash for her one third equity instead of services, could a corporate entity then be viable? (c) If the Business requires an additional $1,000,000 from each Client, discuss the pros and the cons of funding with debt versus equity in the case of each the Business being conducted as a C corporation, an S corporation, and an LLC. (d) The Clients advise you that, at a later date, they may wish to add an adjacent retail establishment and to offer the adjacent landowner a 25% equity interest in exchange for his adjacent parcel, which they understand has already appreciated substantially. Through use of which type(s) of entity, i.e., C corporation, S corporation, or LLC, would the Clients be most likely to accomplish this transaction with no gain or loss to the adjacent landowner and why? (e) Assume for this question Two (e) and question Two (f) only: the Business is an S corporation; bad publicity form the American Dental Association about the harmful impact of popcorn consumption on teeth has caused the Business to suffer huge losses; all three (3) Clients devote their full time efforts to saving the Business; past losses have reduced the basis of each Client in their stock in the Business to Zero Dollars ($0.00); and the Business needs to borrow $1,000,000 from a bank to survive for the next year. Assume further that the Business will operate at a loss for the following year, of about $1,000,000, and that the Clients wish to use the loss on their personal tax returns for the following year to offset unrelated investment income. The Clients let you know in passing that they intend to ask the bank to loan the $1,000,000 directly to the Business for a note, take a mortgage on the building and obtain the personal guaranty of each of the Clients on the note. What tax problems, if any, do you have with this approach? How would you advise the transaction be structured to avoid this issue (i) by converting to a different entity (assuming none of the shares of stock in the Business and none of the assets of the Business have appreciated at all) and, alternatively (ii) even if remaining an S corporation? (f) The bank agrees to change the loan terms as described in (e) above, but as consideration for doing so, the bank has required that the loan be convertible to 10% of the stock of the Business, which, as you recall is an S corporation for purposes of this problem. The Clients ask whether you would approve of this change to the loan documents. What drawbacks to this change to loan documents would you bring to the attention of the Clients? (g) Assume, for purposes of this problem Two (g) only, after three (3) years, the Business has recovered to the point of having a fair market value of $5,000,000; the assets of the Business have no basis and each Client has no basis in her interest in the Business. The Clients believe it is now time to sell the Business before any more well-meaning dentists further besmirch their product. (h) What would be the tax consequences of selling the assets of the Business for $5,000,000 and then liquidating in the case of each the Business being a C corporation, an LLC, an S corporation that has always been an S corporation, and an S corporation that converted from Subchapter C when the assets of the Business had a basis of Zero Dollars ($0.00) and a fair market value of $1,000,000? (Hint: For purposes of all three sections of this problem (g), remember to consider: income taxes at the entity and owner levels; the 3.8% net investment income tax under Code Section 1411; any special taxes applicable to S corporations that were previously C corporations, particularly under Code Section 1374; Code Section 1202; and the ability of buyer to achieve a step-up in the basis of the assets of the acquired entity, which will fetch a higher price on sale.) (ii) What would be the tax consequences of selling the equity of the Business for $5,000,000 in the case of each the Business being a C corporation, an LLC, an S corporation that has always been an S corporation, and an S corporation that converted from Subchapter C when the assets of the Business had a basis of Zero Dollars ($0.00) and a fair market value of $1,000,000? (iv) As opposed to a cash sale, the Business is acquired for $5,000,000 of common stock in a statutory merger, described in Code Section 368(a)(1)(A). What are the differences in the tax consequences for the Business and the Clients if the Business is an LLC, a C corporation, an S corporation without Code Section 1374 built-in-gain, and an S corporation with Code Section 1374 built-in gain? (i) If the Business is to be operated as a domestic LLC, what must the Business file to be taxed as a partnership? As a C corporation? As an S corporation? (j) The Business decides to also sell beer (to wash down the popcorn) and is concerned that liabilities from the sale of beer might attach to the popcorn assets. The Clients, accordingly, wish to conduct the beer sale operations in a wholly-owned subsidiary. What are the various entities available to be used as a subsidiary, assuming that the Business is: an S corporation; a C corporation; and a limited liability company? (k) Regarding (i) above, the Business is an S corporation, (i) if the wholly-owned subsidiary was initially formed as an LLC, what would be the impact of granting a 25% interest in the LLC to a third party; and (ii) if the wholly-owned subsidiary was initially formed as a qualified subchapter S subsidiary, what would be the impact of granting a 25% interest in the qualified subchapter S subsidiary to a third party? (l) The Business has become a cash cow, making large annual salaries and distributions both possible. Suggest an entity choice and plan for accomplishing this in the most tax efficient manner. QUESTION THREE Propose a choice of tax entity and explain your choice in the following instances: (a) A firm that: will provide legal services; expects to be highly profitable; expects owneremployees to earn in excess of $1,00,000 per year; expects to have a substantial workforce; expects to have some corporate owners; and expects to sell the equity (not assets) of the entity for a huge profit sometime in the future. (b) A factory that makes and sells electric cars that is intended to be highly profitable and could ultimately be disposed of in a stock sale, an asset sale, or a merger for stock of the acquiring company. Why might it matter whether or not this entity will currently distribute earnings or accumulate earnings to fund future growth? (c) A venture to own and operate, a commercial office building that will be purchased with cash and a nonrecourse note and that will have losses for five (5) years, before becoming profitable and sold at a gain. QUESTION FOUR List and explain your reasons for listing at least three (3) differences in the tax treatment among two (2) or more of the tax entity choices (i.e., C corporation, S corporation, and partnership) that you feel are illogical or unwise from a tax policy perspective. For example, you might cite the requirement that only S corporations are limited to 100 or fewer owners and then describe why you believe that particular disparate treatment is illogical or unwise. INSTRUCTIONS Unless expressly provided to the contrary, all references to limited liability companies, or LLCs, refer to LLCs that have not elected C corporation or S corporation tax treatment. All references to “Code” refer to the Internal Revenue Code of 1986, as amended. When we refer to “equity,” we mean the asset representing ownership in the venture or entity in the hands of the owner, such as stock in a corporation or a membership interest in an LLC. So for instance, in the case of a corporation, a sale of equity would be a sale by the stockholders of their stock. This should be contrasted with an asset sale, which would mean, in the case of a corporation, a sale by the corporation of its assets followed by a liquidation of the corporation in cancelation of its outstanding shares of stock. When we ask about tax consequences, you will receive full credit for discussing federal taxes only and not addressing state or local taxes. In completing the exam, feel free to use the course outline as well as any research materials or sources, whether written or on line, but please do not talk to each other or to anyone else about the exam. Should you feel a question is ambiguous, please explain the ambiguity and answer the questions as well as you can. Good luck. QUESTION ONE You are planning to meet with three (3) new individual clients (which we will sometimes refer to as the “Clients” throughout this Exam), Betty, Bertha, and Bonnie, in order to advise them what type of entity to form for their new business of the manufacturing and sale of popcorn (which we will sometimes refer to as the “Business” throughout this Exam). At the meeting, what questions would you ask and, in the case of each question, why is the information relevant? QUESTION TWO In connection with the Business, Betty is willing to contribute a building with an adjusted basis to Betty of $2,000 and a fair market value of $2,000,000; Bertha is willing to contribute cash of $2,000,000; and Bonnie has agreed to provide the service of popping the popcorn for three (3) years. (a) The Clients want any future growth in the value of the Business to be shared equally between the three of them, but that none of them be subject to any income tax upon formation of the entity and issuance of equity in the entity to any of them. (i) (ii) (iii) The Clients, who like to keep things simple, suggest they form a C corporation, with a single class of common stock, and that they each be issued an equal amount of shares for their respective contributions mentioned above. What would you advise the Clients are the potential drawbacks of this plan? What might you suggest as an alternative plan and why? In your response, please consider solutions for each an S corporation, a C corporation and an LLC. (b) Betty’s building is subject to a mortgage of $1,000,000 for which Betty is personally liable. Please propose a structure pursuant to which Betty will not recognize any gain on contribution of the building for one third of the common equity of the new entity. Can this goal be accomplished if the entity is a corporation? Why or why not? If Bonnie unexpectedly inherits $2,000,000 and is able to contribute this cash for her one third equity instead of services, could a corporate entity then be viable? (c) If the Business requires an additional $1,000,000 from each Client, discuss the pros and the cons of funding with debt versus equity in the case of each the Business being conducted as a C corporation, an S corporation, and an LLC. (d) The Clients advise you that, at a later date, they may wish to add an adjacent retail establishment and to offer the adjacent landowner a 25% equity interest in exchange for his adjacent parcel, which they understand has already appreciated substantially. Through use of which type(s) of entity, i.e., C corporation, S corporation, or LLC, would the Clients be most likely to accomplish this transaction with no gain or loss to the adjacent landowner and why? (e) Assume for this question Two (e) and question Two (f) only: the Business is an S corporation; bad publicity form the American Dental Association about the harmful impact of popcorn consumption on teeth has caused the Business to suffer huge losses; all three (3) Clients devote their full time efforts to saving the Business; past losses have reduced the basis of each Client in their stock in the Business to Zero Dollars ($0.00); and the Business needs to borrow $1,000,000 from a bank to survive for the next year. Assume further that the Business will operate at a loss for the following year, of about $1,000,000, and that the Clients wish to use the loss on their personal tax returns for the following year to offset unrelated investment income. The Clients let you know in passing that they intend to ask the bank to loan the $1,000,000 directly to the Business for a note, take a mortgage on the building and obtain the personal guaranty of each of the Clients on the note. What tax problems, if any, do you have with this approach? How would you advise the transaction be structured to avoid this issue (i) by converting to a different entity (assuming none of the shares of stock in the Business and none of the assets of the Business have appreciated at all) and, alternatively (ii) even if remaining an S corporation? (f) The bank agrees to change the loan terms as described in (e) above, but as consideration for doing so, the bank has required that the loan be convertible to 10% of the stock of the Business, which, as you recall is an S corporation for purposes of this problem. The Clients ask whether you would approve of this change to the loan documents. What drawbacks to this change to loan documents would you bring to the attention of the Clients? (g) Assume, for purposes of this problem Two (g) only, after three (3) years, the Business has recovered to the point of having a fair market value of $5,000,000; the assets of the Business have no basis and each Client has no basis in her interest in the Business. The Clients believe it is now time to sell the Business before any more well-meaning dentists further besmirch their product. (h) What would be the tax consequences of selling the assets of the Business for $5,000,000 and then liquidating in the case of each the Business being a C corporation, an LLC, an S corporation that has always been an S corporation, and an S corporation that converted from Subchapter C when the assets of the Business had a basis of Zero Dollars ($0.00) and a fair market value of $1,000,000? (Hint: For purposes of all three sections of this problem (g), remember to consider: income taxes at the entity and owner levels; the 3.8% net investment income tax under Code Section 1411; any special taxes applicable to S corporations that were previously C corporations, particularly under Code Section 1374; Code Section 1202; and the ability of buyer to achieve a step-up in the basis of the assets of the acquired entity, which will fetch a higher price on sale.) (ii) What would be the tax consequences of selling the equity of the Business for $5,000,000 in the case of each the Business being a C corporation, an LLC, an S corporation that has always been an S corporation, and an S corporation that converted from Subchapter C when the assets of the Business had a basis of Zero Dollars ($0.00) and a fair market value of $1,000,000? (iv) As opposed to a cash sale, the Business is acquired for $5,000,000 of common stock in a statutory merger, described in Code Section 368(a)(1)(A). What are the differences in the tax consequences for the Business and the Clients if the Business is an LLC, a C corporation, an S corporation without Code Section 1374 built-in-gain, and an S corporation with Code Section 1374 built-in gain? (i) If the Business is to be operated as a domestic LLC, what must the Business file to be taxed as a partnership? As a C corporation? As an S corporation? (j) The Business decides to also sell beer (to wash down the popcorn) and is concerned that liabilities from the sale of beer might attach to the popcorn assets. The Clients, accordingly, wish to conduct the beer sale operations in a wholly-owned subsidiary. What are the various entities available to be used as a subsidiary, assuming that the Business is: an S corporation; a C corporation; and a limited liability company? (k) Regarding (i) above, the Business is an S corporation, (i) if the wholly-owned subsidiary was initially formed as an LLC, what would be the impact of granting a 25% interest in the LLC to a third party; and (ii) if the wholly-owned subsidiary was initially formed as a qualified subchapter S subsidiary, what would be the impact of granting a 25% interest in the qualified subchapter S subsidiary to a third party? (l) The Business has become a cash cow, making large annual salaries and distributions both possible. Suggest an entity choice and plan for accomplishing this in the most tax efficient manner. QUESTION THREE Propose a choice of tax entity and explain your choice in the following instances: (a) A firm that: will provide legal services; expects to be highly profitable; expects owneremployees to earn in excess of $1,00,000 per year; expects to have a substantial workforce; expects to have some corporate owners; and expects to sell the equity (not assets) of the entity for a huge profit sometime in the future. (b) A factory that makes and sells electric cars that is intended to be highly profitable and could ultimately be disposed of in a stock sale, an asset sale, or a merger for stock of the acquiring company. Why might it matter whether or not this entity will currently distribute earnings or accumulate earnings to fund future growth? (c) A venture to own and operate, a commercial office building that will be purchased with cash and a nonrecourse note and that will have losses for five (5) years, before becoming profitable and sold at a gain. QUESTION FOUR List and explain your reasons for listing at least three (3) differences in the tax treatment among two (2) or more of the tax entity choices (i.e., C corporation, S corporation, and partnership) that you feel are illogical or unwise from a tax policy perspective. For example, you might cite the requirement that only S corporations are limited to 100 or fewer owners and then describe why you believe that particular disparate treatment is illogical or unwise.
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