ABA SECTION OF TAXATION
2014 LAW STUDENT TAX CHALLENGE
OFFICIAL LL.M. DIVISION PROBLEM
After grabbing your morning breakfast sandwich and settling into your open floor plan (what
happened to associates having offices in the good old days), you open your email to start another
week at the boutique law firm of Vader & Firefly, LLP. You have gained a reputation as a
promising star and all the partners ask for you to help on a day-to-day basis, save one. V. Riddle
has not spoken a word to you but he has walked by multiple times (it’s unclear if he knows you
exist). As you sort through your email replying to the other partners, you receive an email from
Riddle. Riddle is the Subchapter K heavy hitter at the firm. You open his email not quite sure
what to expect...
Baltar Partnership
V. Riddle <vriddle@vaderfirefly.com>
Sent: Mon 9/8/2014 7:07 AM
To: You
Person sitting in the middle of the floor,
I met with one of my very important clients on Friday and this takes priority over any other work
you have. If you are busy I suggest you turn your 24-hour day into a 30-hour day. My client,
Baltar is an eccentric, but brilliant, robotics engineer who was involved in a partnership that is
now under audit. Baltar is very concerned about the tax implications of his business venture. I
received a brief version of the facts and I want you to paint a picture explaining what happened
inside this partnership.
Baltar is a multi-million dollar client who uses our firm for his various business enterprises and
private equity deals. Please draft a memo, no more than twelve pages in length, and a brief client
letter, no more than four pages, describing Baltar’s situation. Do not feel compelled to provide
the maximum page numbers because they are authorized. If your work is thorough and useful,
you will be in my good graces. A corresponding “payroll glitch” may happen in your favor... if
your work product is useless, the “payroll glitch” will be in the firm's favor. Additionally,
Baltar’s client letter should be straight forward and written in terms that a “lay person” would
understand. Baltar is quite intelligent, but tax is not one of his eccentric hobbies.
There will likely be some other applicable code sections when you address the calculations;
however, the focus of the memo should be on Subchapter K (federal partnership taxation). All
depreciable property is on a five year, straight-line basis. The LLC has adopted the remedial
method. Your substantive Subchapter K analysis will be the determining factor in the outcome of
the payroll glitch. I will be out sailing the seven seas until next week. See my secretary for notes
from my meeting with Baltar. As you have not had a summer vacation, I don’t see why we
should break that streak. Take the lead on this. I expect your memo and client letter on my desk
upon my return.
V. Riddle | Federal Partnership Taxation
Vader & Firefly, LLP
Smith Street
Houston, TX 77002
Phone: Don’t bother calling, I’m sailing
Cell: Never
Client File No. 1998-0043
Meeting with Baltar on Friday, September 5, 2014
Baltar and three other individuals got together over a few pints to discuss the next “in”
technology. Baltar was tired of the phablet fad. The four of them decided to create and build
Wylons.
Wylons are robots, created to “make our lives easier.” To build these Wylons, they formed an
LLC, Galactica Enterprises (Galactica). For other unrelated reasons, Baltar joined Galactica
Enterprises through his single member LLC, Caprica Enterprises (Caprica), which enjoys limited
liability for state law purposes. The partnership was formed on January 1. There was no
affirmative election under the check-the-box regulations. The partners split all items of profit and
losses equally. The partners contributed the following to Galactica upon formation:
Partner
Asset
AB
FMV
Adama:
Land 1
Land 2
150,000
4,800,000
200,000
4,800,000
Baltar (Caprica):
Cash
5,000,000
5,000,000
Cally:
Cap Equip 1
Cap Equip 2
4,500,000
150,000
4,500,000
500,000
Dualla:
Manu Equipment
3,500,000
5,500,000
(subject to 500,000 liability)
The terms of the formation of Galactica were as follows:
1. Adama received $100,000 from Galactica upon Adama’s contribution of the two pieces
of land. Land 1 was an adjacent parcel to Land 2. Further, Land 1 was unnecessary for
any part of Galactica's Wylon operation. Adama did not want to keep it for unrelated
reasons, but wanted to get some cash for its appreciated value. Adama had heard through
“some unsavory friend” that individuals could pull money out of a partnership upon a
contribution, and took his advice.
2. Cally will receive an annual distribution of $25,000 until Cally has received $500,000
before any other distributions are made. Cally’s Capital Equipment 2 is proprietary for
their Wylon operation and Wylons cannot be manufactured without it.
3. Dualla contributed manufacturing equipment to Galactica. Six months before the
contribution, Dualla obtained a $500,000 loan secured solely by the manufacturing
equipment. Dualla used the proceeds to improve the equipment to make Galactica’s
Wylons, and Galactica took the asset subject to the $500,000 security interest upon the
contribution. Galactica and the partners in their individual capacity are not personally or
severally liable for the security interest. However, in order to appease the creditor holding
the security interest on the manufacturing equipment, Caprica agreed to guarantee
$100,000 of the debt. Caprica has and will consistently have assets of $15,000,000 aside
from its interest in Galactica. The four partners split liabilities according to the
partnership agreement.
4. Caprica receives a $35,000 payment every year regardless of Galactica’s earnings for
certain know-how related to the Wylon operation. Caprica has a separate contract from
the partnership agreement regarding this payment.
Over the next three years, the Wylon operation was extremely successful. Galactica generated $4
million of profit each year over these three years before depreciation. The partners then engaged
in the following transactions in Year 3:
1. Galactica distributed Land 1 to Cally and Cap Equip 2 to Adama.
2. In addition, Galactica liquidated Dualla’s interest by distributing money and her share of
inventory. However, Dualla wanted more Wylons as she believed they were a good
investment for the future. Galactica had a basis of $5 million in the Wylons, and they
have a fair market value of $15 million. Dualla wanted an extra $1 million of Wylons in
lieu of cash for her interest.
However, recently, Baltar, having read a lot science fiction, has decided the Wylon operation is
not something he wants to be involved in anymore. The other partners agree the risk to humanity
is too great for their conscience to ignore. Thus, Adama, Baltar, and Cally have agreed to sell
their respective interests in Galactica to Blackstone Industries (Blackstone), an unrelated
corporation. Immediately after the sale (in Year 5), Blackstone will own 100% of the interests in
Galactica.
Voice Message from V. Riddle – Mon 9/8/2014 12:00 PM
A few more thoughts on my client before I hit the high seas…
Based on the details surrounding the contributions each partner made to Galactica, I’d like for
you to explain the consequences of the formation. It is important to know all the tax
consequences of these four transactions in order to advise Baltar on his current situation. It
would be most helpful, as a separate exhibit, to provide Galactica’s balance sheet as well as each
of the partners’ outside basis and capital accounts at formation.
We must explain the tax consequences to the partners of the transactions in Year 3, and you
should update Galactica’s balance sheet as well as the remaining partners’ outside basis and
capital accounts after these transactions.
The balance sheets for both the formation and the Year 3 transactions will not count against your
twelve page limit.
Finally, discuss the potential U.S. tax consequences to Baltar and Blackstone from the sale of
Galactica in Year 5.
If you believe there are any ambiguities, please address these in your memorandum to me.
END OF PROBLEM