EXAM NUMBER: UNIVERSITY OF FLORIDA COLLEGE OF LAW FINAL EXAMINATION TAX II SPRING SEMESTER, 2004 PROFESSOR WILLIS. Instructions

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1 EXAM NUMBER: UNIVERSITY OF FLORIDA COLLEGE OF LAW FINAL EXAMINATION TAX II SPRING SEMESTER, 2004 PROFESSOR WILLIS DATE: April 30, 2004 TIME: 9:00 A.M. TIME LIMIT: FOUR HOURS Instructions 1. You may consult any written materials you consider helpful. 2. Unless otherwise indicated, all parties are on the cash method of accounting and use the calendar year. All parties are unrelated unless otherwise indicated. All parties are single and not heads of households, unless otherwise indicated. 3. Some questions have space provided for a short answer, such as a dollar amount or a single word (e.g., correct or incorrect). You must write an appropriate answer in such spaces. For example, if a question calls for a dollar amount, anything other than arabic numerals stated in terms of U.S. dollars will be incorrect. 4. This exam is due 1:00 p.m. If you are picking up the exam in person, you may take an extra 30 minutes for travel time. 5. Place your exam number or other form of identification at the top of this page. 6. For all periods and all terms short, mid, or long, the AFR is 10.25% nominal annual interest compounded annually, 10% compounded semi-annually, compounded quarterly, and compounded monthly. 7. I will answer no questions prior to the time you turn in your paper.

2 QUESTION ONE Jim loaned George $ 10,000,000 on January I, I997. In exchange, George promised to lease a shopping center to Jim for eight years, beginning January 1, 1999 (the building was then under construction... hence the delayed possession). George will repay the $ 10,000,000, without interest, on December 31, Jim will operate the shopping center as part of his real estate business. To the extent he can, he will sub-lease the space. Both Jim and George are cash method, calendar year taxpayers and are unrelated. What are the 2004 tax consequences to both Jim and George resulting from this transaction? The interest-free loan from Jim to George for the eleven-year period has a present value of the payments equal to 3,418, on 1/1/97. FV = 10,000,000; n = 11; I = 10.25; p/yr = 1; pmt = 0. The remainder of the amount loaned would be characterized as a lump-sum payment from Jim to George on that date of $6,581, Section 7872(b). The loan thus has two parts: 1. It is an OID instrument with an acquisition price of 3,428, and a redemption price of 10,000,000, eleven years later, and an AFR of Because it began on the first of a year and ends on the end of a year, there is no need to use the six-month accrual period: a one-year accrual period would be permissible under the regulations. Jim will have annual interest income and George will have an annual interest deduction under section 1272 and 163(e), respectively. The annual OID amounts are: 350, , , , , , , , , , , These amounts, plus the principal of 3,418, add to 10,000, The question asked the year 2004 consequences. Jim would have interest income in that year of 693, and George would have a corresponding deduction. 2. This is a prepayment of rent in the amount of 6,581, on 1/1/97 for the period 1/1/99 through 12/31/06 an eight-year period. Interest would be accrual by Jim on pre-paid amounts under section 467, using an AFR of , which is 110% of the stipulated AFR. In addition, George would have rent income and Jim a rent deduction of 1,437, for each year 1999 through

3 The question asks for year 2004 consequences: rent income to George and rent deduction to Jim of 1,437, The interest on the pre-paid amounts would accrue in favor of Jim who would have income. George would have a corresponding interest deduction annually. The amounts, starting in 1997 and going through 2005 would be: 742, , , , , , , , , My calculations use begin mode, which assumes the rent is owed at the beginning of each period. The regulations under section 467 are silent on this issue; however, it seems logical considering the assumption of end mode for deferred rent. Year 2006 has no interest because the last installment of rent is taken from the account on 1/1/06 and no additional amount is then pre-paid. The year 2004 amount would be 276,477.01, which would be interest income to Jim and an interest deduction to George. A summary of the year 2004 consequences would be: Jim: interest income of 693, (per 1272) plus 276, (per 467) and rent deduction of 1,437, (per 467). George: interest deduction of 693, (per 163(e))plus 276, (per 467)and rent income of 1,437, (per 467). 3

4 QUESTION TWO Your client received $10,000,000 cash on January 1, Determine his 2003 income from the receipt, depending on the following alternative facts. Explain as you deem necessary. A. The money was an interest-free loan from his employer, due at the earlier of five years or his leaving employment with the company. $_1,025,000 Per 7872(a), the foregone interest would be considered a payment from employer to client on the last day of the year. This is a demand loan because it is conditioned on the performance of substantial future services by an individual. This is 10.25% of $10,000,000. B. The money was a payment for the purchase of Blackacre, real property in which your client had a basis of $1,000,000. Title was transferred to the purchaser in $ 5,768, This would be gain from the sale of the property. FV = 10,000,000, I = 10.25; p/yr = 1; n = 4. Then, subtract the basis. I need to know more precisely when the title transferred. The above number assumes it transferred on 1/1/99. Had it transferred on 12/31/99, the number would be $7,462, C. The money was a payment for personal services to be rendered by your client during the years 2003 to Your client uses the accrual method. $ 10,000,000 Per Schlude, this would all be income in the year received. 4

5 D. The money was an interest-free loan from an S-corporation in which your client owns 30% of the stock and by which he is not employed. Repayment is due in $ 4,949, This would be a payment to client in Whether it is income depends on facts not given it clearly would not be for services; however, it could be a distribution, a dividend, or perhaps even a constructive gift from the other shareholders. I also need to know more precisely when repayment is due. The number given assumes 1/1/2010 as the due date. FV = 10,000,000; I = 10.25; n = 7; pmt = 0; p/yr = 1. $ 517, interest deduction would also be attributed to client per section E. The money was for the use of a cargo ship from 2003 until $ 1,924, This would be rent income for 2003 per section 467(f). I used an amortization calculator in begin mode with an interest rate of % and a period of 7 years. In addition, client would accrue an interest deduction computed at % of the prepaid amount ($10,000,000 minus the rent); however, this was not asked for in the question. F. The money will be received, instead, on December 31, It will be a payment for the purchase of Blackacre, real property in which your client had a basis of $1,000,000. Title was transferred to the purchaser on January 1, $ 3,581, This would be gain on the sale of Blackacre per section FV = 10,000,000; I = 10.25; pmt = 0; p/yr = 8. Subtract basis from PV. In addition, client would have OID interest under section 1272 of $469,

6 Question Three: Client leased a cargo ship to ABC for four years for $10,000,000. The money was placed in a non-interest bearing escrow account beyond the reach of ABC s creditors. Client cannot borrow on the account and cannot receive the money for four years. Client uses the cash method of accounting. Analyze the relevance of the economic benefit doctrine and section 467. I am less interested in your calculations than in your analysis of how the doctrine relates to the code section. Please limit your answer to 1-1/2 pages. This is deferred rent under section 467 and should be subject to accrual under that section. If the scheme successfully avoided the economic benefit doctrine, it would do client little good: 467 would require accrual over time. The economic benefit doctrine if it applied would cause this to be income in the year of the transfer to the escrow account in the amount of the present value. In any event, the economic benefit doctrine has not historically applied to cases involving the use of property: courts have consistently limited it to cases involving services or contest winnings. But, section 467 would probably then trump that section to amortize the pre-payment, resulting in the same answer of accrual over time. The point of this question was to show that 467 essentially makes the economic benefit doctrine and controversy irrelevant in cases involving the use of property. Section 1274, at least in part, does the same thing for cases involving the sale of property. Most papers gave me the history of the economic benefit doctrine (irrelevant to the question) and general rules regarding 467 (also irrelevant to the question). I asked for the relevance of the two: economic benefit doctrine is very likely irrelevant because of 467!!! 6