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Federal Income Taxation

December, 2000

Professor Chirelstein

Time Allowed – Three hours


This is a limited open-book examination. You may bring with you to the examination
room your Code and Regulations volume, but nothing else.

The examination consists of 10 equally weighted short-answer or short-essay questions.

Answer all of them. For Questions 3 and 8, no more than names and numbers may be needed.
For the others, two or three brief but highly legible paragraphs explaining your reasoning will be
appropriate. If you finish early, good!

Q 1. Dorothea, age 40, is the life tenant of a trust created by her deceased father. The trust
generate income of $20,000 a year. Dorothea doesn’t need the income at present, so she assigns
to her son, Ladislaw, by gift the right to receive all the trust income for the next 5 years.
Ladislaw, a medical student, has large credit card debts, which he is desperate to pay off.
Accordingly, he sells his 5-year income right to a local investor for $65,000 cash, paid in a single
lump sum.

What are the tax consequences of these events to Dorothea and Ladislaw? Explain.

Q 2. Andrew was injured in an auto accident and sued the other driver for $10,000. The other
driver’s insurance company offered to settle Andrew’s claim for $2,000, but Andrew rejected
that offer. Pierre, Andrew’s tailor, has presented Andrew with a bill for making two new suits in
the amount of $3,000. Unable to pay, Andrew persuades Pierre to accept an assignment of his
damage claim in full satisfaction of Pierre’s bill. Ultimately, and to everyone’s surprise, the
insurance company agrees to settle Andrew’s claim for $9,000 and pays that amount over to
Pierre as assignee.

What are the tax consequences of these events to Andrew and Pierre? Explain.

Q 3. Brangwen owns Glenview, investment property, with a value of $110,000 and a basis of
$100,000, which is subject to a mortgage of $20,000. Rupert owns Harborview, also investment
property, with a value of $60,000 and a basis of $40,000. Brangwen and Rupert exchange their
properties and Rupert pays Brangwen $30,000.

What are the tax consequences of the exchange to Brangwen and Rupert?

Q 4. Under a special Code provision, breeders of llamas are allowed to report the profit realized
on the sale of their animals as long-term capital gain. The initial cost of breeding a llama is
about $5,000, and the breeder can usually get $15,000 for the creature at the end of four years
when the llama is an adult. Taxed as long-term capital gain, the breeder pays a tax of 20%, or
$2,000, on his $10,000 profit, having treated the initial breeding cost as a non-deductible capital
expenditure. The US Treasury, which regards the llamas as “inventory” in the hands of a
breeder, has urged Congress to change the law and treat the gain on llama sales as ordinary
income. As a sop to the llama lobby, the Treasury has stated that if this change is made, it will
allow breeders to deduct the initial breeding cost as a current expense.

How should llama breeders feel about the Treasury’s proposal? Explain.

Q 5. Odette is the owner of a movie theater in Omaha, which she has operated with moderate
success for many years. Last year the Omaha City Council adopted a new fire passageway
regulation, of which the effect was to require Odette to tear out several rows of seats and make
certain changes in the width of windows and exit doors. The cost of all this was $25,000.

How should Odette treat the $25,000 outlay? Explain.

Q 6. Knowing you to be a tax specialist, a friend writes you a letter, saying “The charitable
deduction is unfair because it treats taxpayers who donate money to charity more favorably than
it treats taxpayers who donate their own services. My services as a dental technician are worth
$40 an hour. I work one day a week for no pay at a charity clinic, and when I tried to deduct the
value of my donated services, the IRS disallowed the deduction. Not fair!!”

What is your reply?

Q 7. Tom, an amateur cook, is famous among gourmets for inventing five delicious dishes using
fresh horsemeat (stew, fricassee, kabob, etc.). Nobody knows Tom’s secret recipes. Tired of
cooking, Tom gives the recipes to his daughter, Sophie, who puts them in a bank vault for safe-
keeping. A couple of years later, Sophie receives an offer from a cookbook publisher to buy the
recipes for $5,000. Sophie accepts.

What are the tax consequences of these events to Tom and Sophie? Explain.
Q 8. Joachim bought General Motors stock some years ago for $75,000, investing $50,000 of his
own money and borrowing $25,000 from his broker. At a time when the stock was worth
$160,000, Joachim borrowed another $50,000 from his broker and then gave the stock to his son,
Hans, subject to both the initial and the subsequent indebtedness. Hans later sold the stock for
$140,000 and paid off all the debt.

What are the tax consequences of these events to Joachim and Hans?

Q 9. Lafcadio, a second year student at Columbia Law School, is invited by a Los Angeles law
firm to fly out to LA for a job interview. The firm pays for Lafcadio’s round-trip flight, $1,000,
for one night in a hotel, $250, and for dinner and breakfast, $75. Unfortunately, Lafcadio makes
a poor impression and the law firm does not offer him a job.

How much, if anything, does Lafcadio have to include in gross income by reason of the interview
in Los Angeles? Explain.

Q 10. A quick and decisive solution (supported by some academics) to the so-called marriage
penalty problem would be to require all individual taxpayers, married or single, to file separate
tax returns.

Is that a good idea? Explain.