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FEDERAL INCOME TAXATION

L6256X

Final Examination - - December 1995

Professor Chirelstein

Time Allowed - - Three Hours

This examination consists of five pages. Check now to


see that your exam has all five pages.

ANSWERS MUST BE WRITTEN IN INK OR TYPEWRITTEN.

IF YOU ARE A CANDIDATE FOR GRADUATION IN FEBRUARY, 1996, WRITE ON THE COVER
OF YOUR FIRST ANSWER BOOK (OR, IF TYPEWRITTEN, AT THE TOP OF YOUR FIRST PAGE),
"CANDIDATE FOR GRADUATION IN FEBRUARY, 1996."

INSTRUCTIONS:

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

Answer each of the following questions - - there are four - - in sufficient detail to convey your
reasoning as well as your conclusions, but please use no more space than is really necessary. And do,
please, write legibly.
_________________________________

Question I

Walgreen Co., a drugstore chain, has for some years operated a pharmacy in the Northpark Mall

outside Milwaukee. Under the terms of Walgreen's lease (which still has six years to run), the Mall owner,

Sara Creek Property, Inc., promised not to lease space in the Mall to any other store that operates a

pharmacy. In 1994, concerned that its main tenant (K-Mart) was about to close up and move, Sara Creek

informed Walgreen that it planned to replace that tenant with a large store operated by Phar-Mor Corp., a

deep-discount chain, that would in fact contain a pharmacy. Walgreen promptly brought suit against Sara

Creek in State court seeking specific performance of the lease restriction mentioned above. The suit was

successful: the State court entered a permanent injunction prohibiting Sara Creek from renting space to

Phar-Mor until the Walgreen lease expired.


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Immediately after the court's decision, Walgreen offered to terminate the lease restriction (in effect,

release Sara Creek from the injunction) for a cash consideration of $250,000. Sara Creek is unable to pay

so large a sum but Phar-Mor, which anticipates good business at the Mall despite the continued presence of

the Walgreen pharmacy, has stated that it is prepared to accept Walgreen's offer and pay the $250,000 in

exchange for Walgreen's agreement to dissolve the injunction.

All three parties - - Walgreen, Sara Creek, and Phar-Mor - - now ask you to analyze the federal

income tax consequences of the proposed deal. Advise each of them.

Question II

Early this year the New York City Fire Department promulgated a new set of physical fitness

regulations which apply to all firemen who are engaged in daily fire-fighting activity. Under the new

regulations, any fireman who is more than 25 pounds overweight on December 15 (based on Tables

published by a well-known health insurance company) will be subject to demotion in grade or even

dismissal. Jones, Smith and Brown were all well over their respective weight limits at the time the new

regulations were issued. Each responded to the regulations in a different way, to-wit:

Jones joined a physical training program and hired a personal nutritionist to help him lose weight.

He succeeded in getting his weight down to the required level by the deadline date and, hence, has been

able to keep his regular job on the fire truck. The cost of the training program and the nutritionist's

services totalled $1,500.

Smith brought a legal action against the Fire Department seeking to enjoin enforcement of the new

fitness regulations on the ground that those regulations were arbitrary and capricious. He lost in the trial

court but has taken an appeal, pending the outcome of which he has been permitted to remain at his usual

job. His legal fees (so far) amount to $1,500.


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Brown reacted by signing up for a six-month course in "accounting and management" at Pace

College. The course enabled him to pass an exam for, and actually obtain, an administrative post within the

Fire Department. The fitness regulations apply only to active-duty fire-fighters but not to administrators

and other office personnel. The salary Brown now receives as an administrator (clerk) is slightly less than

the salary he got as a regular fireman. The Pace College course cost him $1,500.

Jones, Smith and Brown all want to know whether they can deduct their $1,500 outlays. What is

your advice to each?

Question III

In his campaign for the Republican presidential nomination this year, Senator Richard Lugar of

Indiana has proposed that we scrap the present federal income tax and substitute for it a national sales tax.

Such a sales tax (like our State and City sales taxes) would apply to the purchase at retail of all goods and

services (maybe with various limited exemptions, e.g., medical care). Certainly one advantage of the Lugar

proposal (others are claimed) is simplification -- no more individual income tax returns, no more audits by

revenue agents, and so on.

Despite the simplification benefit, one learned commentator, interviewed on the evening news, has

characterized -- and by implication denounced -- the Lugar proposal as "nothing more or less than a tax on

wages". A friend of yours, having heard the interview, admits to being puzzled by the quoted statement.

Why is a sales tax, she wonders, equivalent to "a tax on wages"? Accordingly, she now asks you to try to

explain that statement to her and to say whether you think the statement is accurate.

Your friend is in a hurry to keep an appointment, so she hopes you can enlighten her in not more

than 3 or 4 booklet pages. Do it.


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Question IV

Howard, an investment banker, enjoyed some very high income years back in the mid-1980's and in

1985 bought a vacation home in the Hamptons for $1,150,000. Howard paid $100,000 out of his own

resources and borrowed the balance, $1,050,000, on a 10-year mortgage from the Long Island Savings Bank

(the Bank). The vacation home was the securing property, of course, and Howard, like almost all residence

purchasers, assumed personal liability for the mortgage - loan.

Howard's income has declined sharply during the past few years and he now finds himself unable to

meet the monthly mortgage payments when due; indeed, he is several months behind at present. As a

result, the Bank has announced that it intends to foreclose. To make matters worse, the Hampton vacation

home has plummeted in value and is now appraised at only $400,000. The unpaid principal balance of the

mortgage-loan (Howard did pay off $50,000) currently stands at about $1,000,000.

Fortunately (in a sense), Howard also owns a regular family residence in Westchester with an

appraised value of $800,000. There is no debt on the Westchester residence -- Howard owns that property

free and clear. Howard's cost for the Westchester residence, which he bought a long time ago, is $300,000.

In order to avoid the Hampton foreclosure (a terrible embarrassment, among other things), Howard

has proposed to the Bank that the Westchester residence - - which, at least, has an appraised value twice

that of the vacation home - - be substituted for the Hampton property as security for the $1,000,000

mortgage debt. If this is done, however, Howard insists (a) that the mortgage-loan be converted into a

nonrecourse obligation, one that would


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involve no personal liability for him in the event of a future default, and (b) that the mortgage-loan itself be

changed from a 10-year to a 30-year loan so that the monthly payments will be less burdensome. The

Bank, eager to avoid the cost of a foreclosure proceeding, is apparently interested in Howard's proposition

and may well accept it.

Having recently described the above proposal to one of his golfing friends, Howard was surprised

to hear the friend mutter something about possible income tax consequences to Howard himself if the

proposal should be accepted by the Bank. Worried, Howard consults you. Advise him.

End of Examination