Scenario #1

Bridget receives taxexempt interest of $33,000 on bonds that are classified as private activity bonds. She properly excludes the $33,000 from her gross income for regular income tax purposes. Bridget asks your advice on the treatment of the interest income for AMT purposes.

Scenario #2

Five years ago Bridget decided to purchase a 10% interest in a limited partnership fastfood restaurant conveniently located near the campus of California State University Fullerton. The general partner of the restaurant venture promised her that the investment would prove to be a winner. During the process of capitalizing the business, $2 million was borrowed from Northside Bank; however, each of the partners was required to pledge personal assets as collateral to satisfy the bank loan in the event that the restaurant defaulted. Bridget pledged shares of publicly traded stock (worth $200,000, basis of $75,000) to satisfy the banks requirement.

The restaurant was successful and profitable until just recently, when flagrant health code violations were discovered and widely publicized by the media. As a result, business has declined to a point where the restaurants continued existence is doubtful (assume that the restaurant remains open during the tax year). In addition, the $2 million loan is now due for payment. Because the restaurant cannot pay, the bank has called for the collateral provided by the partners to be used to satisfy the debt. Bridget sells the pledged stock for $200,000 and forwards the proceeds to the bank. Bridget believes that her share of the restaurants current and suspended passive activity losses can offset the $125,000 gain from the stock sale. As a result, after netting the passive activity losses against the gain, none of the gain is subject to tax. How do you react to Bridgets position?

The client letter must answer these questions (ignore the atrisk rules in all of your answers)

Q1) Explain how the interest from private activity bonds is treated for AMT purposes (include the primary source citation)?

Q2) The $125,000 gain on the sale of stock is either a Longterm capital gain, or a passive activity gain. Explain how these two different treatments will affect the calculation of Bridgets tax return (assume she is in the 25% marginal tax bracket for ordinary income).

Q3) What is the definition of a passive activity (include the primary source citation)?

Q4) Provide a primary source citation for items that are specifically excluded from passive activity

treatment (no need to list them all, just provide the source).

Q5) Make a determination as to whether the gain on the pledged stock is capital or passive gain. Justify your decision using the primary sources in Q2 and Q3.