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1995 Exam Model Answer

1995 Exam Model Answer

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Federal Income Taxation --- Fall, 1995 Prof.

Chirelstein Summary of possible exam answers: Question I: The outcomes may depend on whether the deal is characterized as a two-party transaction involving only Walgreen and Phar-Mor or a three-party transaction involving a payment of $250,000 by Phar-Mor to Sara Creek and then a subsequent payment by Sara Creek to Walgreen. If characterized as a two-party transaction: Phar-Mor has made a capital expenditure of $250,000, which it should amortize over the 6 years remaining on the Walgreen lease. Sara Creek is apparently unaffected for tax purposes. Walgreen might get capital gain treatment on the theory that it has sold a "property encumbrance (protected by the injunction) to a third party. The Ferrer case would be helpful authority from the taxpayer's standpoint. On the other hand, Walgreen could be viewed as having received a lumpsum payment representing the value of 6 years' future business income and, as a result, get ordinary treatment. Sort of a carved-out interest issue, and debatable. If characterized as a three-party transaction: Phar-Mor has again made a capital expenditure, but that outlay would be regarded as prepaid rent (to Sara Creek) and would be amortizable over the term of Phar-Mor's own Mall lease, a period which could be either shorter or longer (more likely longer) than the 6 years remaining on the Walgreen lease. Sara Creek is in an especially chancy legal position: it has $250,000 of prepaid rental income, all taxable in the year "received" (from Phar-Mor), but then would be seen as having made a capital expenditure, amortizable over the 6-year term, when it "paid" the same amount to Walgreen to eliminate the lease restriction. Walgreen would be regarded as having agreed to a lease modification rather than as having sold a property right to a third party. In that event, section 1241 governs the outcome. while section 1241 specifically allows capital gain for the "cancellation" of a lease (despite the absence of a "sale or exchange"), it might be inferred that Congress did not view "modification" of a lease in an equally favorable light. Do Regs. sec.1.1241 give any guidance? Two-party or three-party? Three-party, it would seem, despite the rather stern results. The injunction, after all, runs against Sara Creek; both technically and in fact, it is Sara Creek's rights that are enlarged when Walgreen agrees to the release. True, the deal in Ferrer was treated as a two-party rather than a three-party transaction, but the question (two or three?) was never raised by the IRS and the Court didn't have to face it. [Strictly irrelevant: Sec's 102, 104, 108, 2703.. .1 Question II: The personal expense/business expense distinction is a burden to the system, a heavy one. But that doesn't mean that case-by-case analysis can be avoided - -indeed, that's exactly whv it's a burden. It's not enough to say simply that a given outlay is normally personal or normally business. Rather, the question, often difficult and time-consuming, is how to classify the outlay from the

standpoint of the particular taxpayer and his (inevitably) special circumstances. "Life in all its fulness. . etc." Jones spends $1,500 on a nutritionist and a physical training program. Deduct? Maybe, maybe not. Diet and fitness programs are so widely used and so fashionable at present that the IRS would fear a flood-gates response on the part of all kinds of professions and occupations, as well as sellers of the services in question. This year, to be sure, Jones did what he did to keep his job. But what about next year, when Jones continues his costly training program in order to hold his weight down? And the year after? And why just Jones? why not every fireman (policeman, doctor, lawyer) who joins a gym (or buys home equipment) for the same purpose? Not wanting to invite such a widescale reaction, the Tax Court might find that the personal and professional elements were an "inseparable aggregate" and deny deduction. But isn't the foregoing a bit too general, given the ultimatum and deadline that Jones faces? The FD expects and requires Jones to lose weight if he wants to keep his job, because the job itself calls for physical stamina and agility (and little else). Surely a professional athlete can deduct his training and fitness expenses; no doubt all do. Jones doesn't have to hit a baseball or block a linebacker, but he does have to run up a ladder, duck falling timbers and carry unconscious bodies through the smoke. Takes muscle, you know? At least let him deduct this year's outlay, which represents a direct and reasonable response to the new FD regulation; as to future years and other taxpayers, we'll worry about those cases as and when they arise. Smith spends $1,500 on a lawsuit challenging the Dept regulations as arbitrary. Deduct? Probably. Details aren't given, but the chances are that firemen have civil service rights and can't be discharged without "cause". whether overweight is "cause" is litigable, no doubt. Expenses incurred by an employee to enforce or defend his employment status (contractual or statutory) are surely deductible as business expenses. There's no "personal" benefit in a lawsuit, no flood-gates danger, and the "ordinary and necessary" requirement is easily met since the taxpayer's continued employment is at stake. Maybe the IRS could argue that the status of the $1,500 outlay cannot be determined until Smith's appeal is decided. If he loses, all his legal expenses are then deductible; but if he wins, such expenditures should be capitalized and amortized over the term of his employment (or something). Not too compelling, though debatable. Brown spends $1,500 taking a course that qualifies him to be an office-clerk instead of a fireman. Deduct? Possibly. Regs. sec.1.162-5, indispensable on this question, roughly distinguish between qualifying for a "new employment" (non-deductible) and retaining an "established employment" (deductible), so Brown's status as a continuing employee of the FD at least gives him a start. Regs. Sec.1.162-5(b) (3) may be critical. That section says: "In the case of an employee, a change of duties does not constitute a new trade or business if the new duties involve the same general type of work as is involved in the individual's present employment". So, where are we? "...same general ..... .?" Climb a ladder and swing an axe v. pound a typewriter and keep the books? Clerical work certainly involves a separate set of skills, and perhaps for that reason such work should be regarded as a "new employment" and the deduction be denied. But isn't that analysis rather narrow and unrealistic? All this effort (on Brown's part) is taking place within the Fire Department, as noted. Couldn't Brown argue that firefighter-to-clerk is a kind of natural career progression as you get older (fatter and weaker)? Surely Brown's experience as a firefighter contributes to his efficiency as an FD administrator - - he knows whereof he's administering -- so that one can easily perceive an element of benefit to Brown's present employer. Anyway, the above-cited Treasury Regs are chiefly concerned with education costs leading to the improvement of one's professional status. The aim is to identify expenditures that can be treated as "personal" - - hence nonrecoverable - - though actually capital in nature. But the cost of retraining for a downgraded post, especially when designed to avoid sudden loss of employment

or forced retirement, looks quite different: more like a "repair" expense, to put it cornily. Had the FD reimbursed Brown, would the reimbursement be taxable? Probably not. Of course it didn't. Question III: "why is a sales tax equivalent to 'a tax on wages'?" asks your friend. Easy question. A taxpayer can derive income from only two sources: wages and investment. If we eliminate the tax on investment income, only wages remain. So the question becomes: does a sales tax somehow eliminate investment income from the tax base? Answer: Yes. Under a sales tax regime, consumption outlays are subject to tax but amounts allocated to savings and investment are not. Thus, if somebody earns $1000 this year, spends $600 and saves and invests $400, the $600 spent is taxable but the $400 saved and invested is deductible. On analysis, it turns out that treating the $400 invested as deductible is the same as treating the income (the yield) derived from such investment as exempt. Ergo, a sales tax is equivalent to a tax on wages only. Familiar illustration: Assume a 40% taxpayer and a 10% interest rate. Under a yield-exemption system, the $400 saved is taxed in Yr 1 and the taxpayer has $240 left to invest. He receives $24 of interest in Yr 2. Such interest is exempt, and hence the taxpayer has $24 after tax. Under a current deduction system, the $400 saved is not taxed in Yr 1. The taxpayer receives $40 of taxable interest in Yr 2, and similarly is left with $24 after tax. The result under a yield-exemption system is thus equivalent to the result under a current deduction system. In effect, investment income can be removed from the tax base either by exempting such income or by allowing the original investment to be deducted. Yield exemption = current deduction. Since a sales tax allows current deduction, sales tax = yield exemption. Once again, personal services and capital investment are the only income sources. If income from investment is exempt, "wages" remains the only taxable receipt. It follows that a sales tax is equivalent to a wage tax just as the learned commentator asserted. Your friend gives you an odd look and hurries off to keep her appointment. question IV: Howard owes the Bank $1,000,000 and is personally liable for the debt. With the Bank's consent, Howard converts the personal loan into a secured nonrecourse loan, the securing property being worth $800,000. The personal loan had a 10-year maturity; the nonrecourse loan matures in 30 years. Any tax consequences to Howard? Maybe you could make out 3 possible results (of which, I admit, #1 is most likely, though the others, #2 especially, need to be considered). #1. No consequences at all. Crane, Parker v. Delaney and especially Tufts stand for the general proposition that personal and nonrecourse loans are to be treated alike (i.e., as if both were personal). Since Howard continues to "owe" the Bank $1,000, you could say (citing the cases just mentioned) that switching from personal debt to nonrecourse debt should be disregarded for income tax purposes, although the switch obviously has economic significance to the parties. On this view, as long as the face amount of the debt is unreduced, neither Howard nor the Bank

would be held to have done anything that has a tax effect. #2. But how about that good old "economic significance"? The Bank previously had a claim on $1,000 of Howard's personal wealth. Now it has a claim on only $800 (assuming the proposed deal is done). The face amount of the debt remains $1,000, it's true, but the excess of $200 over the market value of the securing property has no current financial value whatever. Wouldn't the Bank have a pretty good argument if it now took a $200 bad debt loss? For the same reason, shouldn't Howard have to recognize $200 of debt cancellation income at this point? The "new" 30-year mortgage bears little resemblance to the "old" 10-year mortgage. Practically speaking, it is "as if" Howard borrowed $800 cash by mortgaging the Westchester property nonrecourse, and then used that borrowing to pay off his outstanding personal debt of $1,000. If he actually did that, of course, there would be no doubt about taxability. So: is there any real difference between what Howard proposes to do and what Kirby Lumber did when it repurchased its outstanding debentures for less than face amount? There's some, admittedly, since the Bank can claim any further appreciation in the Westchester property up to $200 if Howard defaults. But will that be a saving factor? The Knetsch case, and even more clearly the decision in Estate of Franklin, support the proposition that nonrecourse debt lacks bona fide status if (or to the extent that) its economic significance depends on substantial subsequent appreciation in the value of the securing property. Here, the property would have to appreciate a further 25% ($800 to $1,000) before the original debt became fully collectible. For tax purposes, therefore, maybe the original debt of $1,000 should be deemed to have been scaled down to equal the value of the substituted collateral -- $800. #3. The Westchester property cost $300 and is now worth $800. Might there be a "realization" problem? If we viewed the proposed arrangement as involving an exchange of the Westchester residence for the release of Howard's personal debt, it would follow that the $500 ($800-$300) of appreciation would be deemed realized and hence taxable as capital gain. If I owe my tailor $10 and he accepts in satisfaction stock that cost me $3 and has a value of $8, I suppose it could be argued that I have both $2 of ordinary debt-cancellation income and $5 of realized capital gain. Or perhaps the "exchange" would not be fragmented in that fashion (see the majority's rejection of Justice O'Connor's concurring opinion in Tufts); if not, the result would be a $700 capital gain and no ordinary debt-cancellation income at all. To be sure, Howard hasn't given up equitable ownership of the Westchester property, and Woodsam holds that nonrecourse mortgaging is not a realization. So perhaps the idea that the property has been "exchanged" is rebuttable. Even so, the West. property is the essential element in a deal that enables Howard to eliminate his personal indebtedness, and in that sense it might be said to have been converted, or "drawn down", rather than merely used as collateral. * A lot depends on whether Howard's original mortgage debt would be deemed to have survived the proposed restructuring - - or whether, on the other hand, the new arrangement would be considered to have taken the place of the old. If the former, then the well-established Crane rule -- viz., that personal and nonrecourse debt are indistinguishable for tax purposes - - would pretty clearly point to the no-tax result in #1. Otherwise, if the latter.

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