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1992 Exam

1992 Exam

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Published by: Yin Huang / 黄寅 on Nov 30, 2010
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FEDERAL INCOME TAXATION L6256y Professor Chirelstein Final Examination - April 1992 Time allowed - Three Hours This exam consists of 4 pages. Check now to see that your copy has all the pages.


Instructions: This is a limited open-book examination. You may bring your Code and Regulations volume to the exam, but nothing else. Answer each of the following questions -- there are five -- in sufficient detail to convey your reasoning as well as your conclusions. But please be brief. Not more than two (or at most three) bluebook pages should be needed for any question; for some, a single page, maybe only a paragraph, should be enough. No credit whatever is given for irrelevant discussion.

I. In Year 1, Aunt, a real estate investor, bought a small office building for $1,000,000, paying $100,000 out of her own resources and borrowing $900,000 from a bank on a non-recourse mortgage. During the subsequent period of her ownership Aunt deducted depreciation of $300,000. Also, she repaid $100,000 of mortgage principal, reducing the outstanding mortgage balance to $800,000. In Year 4, Aunt deeded the building, still subject to the $800,000 mortgage, to Neph as a gift. The fair market value of the building at that time was still $1,000,000. Neph took depreciation of $50,000 during the period of his ownership but made no further payments of mortgage principal. In Year 6, following a sharp decline in the real estate market, the building burned down completely. Neph carried fire insurance on the building but the insurance company would agree to a valuation for the property of only $700,000 as of the date of the fire. Since the latter figure was less than the remaining mortgage debt, all of the insurance money was paid to the mortgageebank. What are the tax consequences of these events to Aunt in Year 4 and to Neph in Year 6?



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Bob and Christina were divorced a few years ago, Christina getting custody of the couple's two minor children. The divorce settlement contained no alimony provision -- as mentioned below, both parties had substantial professional earnings -- but it did obligate Bob to make child-support payments of $20,000 a year. The settlement also provided that Bob was to promptly pay off a mortgage of $35,000 on a vacation home in Maine used by the family but owned by Christina. Finally, it was agreed that Bob, who was then a practicing architect, was to pay Christina, a practicing engineer, $12,000 for consulting services which Christina had performed in connection with a building project being carried out by Bob's firm. Bob paid the child support regularly for the first twelve months or so but then stopped completely (having for various reasons lost his architect's license), leaving Christina to support the children on her own. Bob never paid off the mortgage on the home in Maine and, similarly, never paid Christina for her consulting services. Christina sued Bob last year in state court and received a judgment of $87,000, which included (a) $40,000 of unpaid child support, (b) the $35,000 due on the mortgage, and (c) the $12,000 consulting fee. Bob, however, is totally broke and it is now clear that no portion of the judgment will ever be satisfied. Christina earns a considerable amount from her own work as an engineer and from other sources. She would like to take a tax deduction this year for the worthless judgment that she holds against Bob. Can she? Explain.

III. (a) Max is a mid-level executive who smokes two packs of cigarettes a day and is twenty-five pounds overweight. His employer, a large manufacturing company, maintains a group Health-Insurance Plan for all of its employees and pays a very sizable annual premium to the insurance carrier. In order to reduce or control its insurance costs Max' employer announces that individual employees who smoke and/or are more than ten pounds overweight as of 6 months after the announcement date will be dropped from the Plan or will have to pay their own insurance premiums. In Max' case the premium would be about $3,000 a year. Max reacts to this by (i) enrolling in Break That Habit, a stopsmoking program that is run by a private organization, and (ii) joining Look Fit and Live, a gymnasium and fitness program also run by a private organization. Max pays fees of $2,500 to "Break..." and $4,000 to "Look..."


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At the end of the 6-month period Max has stopped smoking (can't even stand to be in the same room with a smoker) and is lean, trim and muscular. His employer very gladly agrees to continue Max' health insurance coverage. Max now wants to know whether he can deduct the cost of the two programs on his federal income tax return. Advise him. (b) As respects the fee paid to "Break...", would your advice be the same or different if Max' employer had accompanied the above announcement with an offer to pay directly (up to $2,500) for any stop-smoking program in which its employees who were smokers chose to enroll, and in fact had paid Break's fee directly? Explain.

IV. Musical Melody Co. owns and operates a large recording studio in lower Manhattan. Musical provides performance rooms, recording facilities and other technical services to local artists wanting to make tapes for audition purposes. The company has been in existence for forty years. A few months ago Clanging Brass Co. took space next door. Clanging runs a machine shop and its operations are sometimes very noisy. Unable to fully use its studio because of the noise, Musical threatened to bring an action against Clanging on grounds of nuisance and business interference. Negotiations ensued. Anxious to avoid litigation, the parties agreed to settle their dispute in the following simple manner: Musical would soundproof its performance studios at a cost of $60,000, of which Clanging would pay two-thirds, or $40,000, and Musical itself would pay the balance of $20,000. The soundproofing work has now been completed and paid for. Both parties being reasonably well satisfied, the only questions remaining are: How should Musical, and how should Clanging, report these events for federal income tax purposes? What are your answers?

V. Harold is a professional numismatician (i.e. , he buys and sells rare coins for a living). In Year 1, Harold pays a visit to an old gentleman who (Harold has heard) owns an 1873 ten-cent piece that bears the mark "D" for Denver mintage. Such coins are very rare and presumably worth a good deal to coin collectors. Harold examines the coin and takes pictures of it but cannot immediately decide whether the "D" is genuine or counterfeit. Accordingly, he pays the old gentleman $1,000 for a purchase-option. The option gives Harold the right to buy the coin at a price of $9,000 any time within the next 18 months. Harold then spends some time traveling around the country examining other "Denver dimes" and consulting various experts in the field in an effort to make a decision about the matter. His expenses in this connection (travel costs, books, fees to other experts) amount to $6,000. Harold deducts the $6,000 as a business expense in his Year 1 income tax return. In Year 2 Harold suffers a fairly serious illness and, as a result, decides to retire from the coin-dealing business completely. He sells off his coin inventory for cash but is unable to find another dealer who is interested in taking over his option on the Denver dime. Finally, he assigns the option by gift to his daughter, Susan, an unemployed folk-singer. Susan decides to take a chance. She borrows $9,000 from a bank, exercises the option (it hasn't yet expired), and in due course receives the dime from the old gentleman.


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Susan's decision turns out to have been a lucky one: the dime on further analysis is found to be genuine. Susan at once gets an offer of $30,000 for the dime from another dealer. Harold advises her to accept the offer at once, but Susan, ever the gambler, decides to keep the dime for a while in the hope of a rise in the rare coin market. Her decision turns out well. In Year 3 the same dealer offers Susan $50,000 for the coin and this time she sells. What are the tax consequences of these events to Harold and to Susan?


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