Federal Tax exam: sample answers

Spring, 1999

1. Last year Ursula won $1,000 playing the horses but lost $600 shooting craps at an Atlantic City casino. Also last year, Ursula sold her diamond ring for $600 more than it cost her but sold her fur coat for $1,000 less than it cost her. As a consequence of all this, Ursula's accountant told Ursula that $1,000 must be added to her gross income for the year. Is the accountant right? Explain (briefly). Answer: Right. Though personal gambling losses ($600) can be offset against gambling gains ($1,000). No offset against the gain from the ring sale ($600) for the loss ($1,000) on the sale of the fur coat.

2. Suppose Father buys stock for $1,000, retains a right to receive the dividends for 10 years, and gives the remainder to Daughter. Assume the present value of Father's retained dividend right is $600. § 167(e)(1) was added to the Code in 1989 at the Treasury's insistence to deal with a significant tax “problem” arising out of the arrangement just illustrated (and certain similar arrangements). What "problem" might the Treasury have been concerned about? Answer: Stripping the remainder arguably leaves Father with a wasting asset, i.e., the 10-year dividend right, which he would be entitled to amortize under general principles. Can't permit that, however, when income right and remainder are held by family members: otherwise everybody would do it, thus rendering investment in corporate stock depreciable.

3. XYZ Insurance Co. wants to offer a new type of insurance policy under which an individual will be insured for x% of any federal or New York State income tax deficiency found to be due following an audit of the individual's tax returns by either the IRS or the State tax authorities provided, among other things, that the returns were prepared by a certified public accountant). XYZ would like to advertise (truthfully) that any and all recoveries under the policy will be exempt from federal income tax. Can it do so? Answer: State yes, federal no. Just the Old Colony case.

4. Some years ago Rupert bought a large tract of undeveloped land for $100,000, drawing the entire purchase price from his own resources. Later Rupert mortgaged the land for $75,000, the mortgage being non-recourse. Rupert had made mortgage principal payments of $15,000. This year Rupert sold the land to another investor subject to the unpaid mortgage principal, now $60,000, and received cash from the buyer in the amount of $65,000. How much gain or loss, if any, will Rupert recognize on the sale? Answer: He invested $115,000 (100 + 15) and withdrew $140,000 (75 + 65). Must have a gain of $25,000.

5. The so-called marriage penalty is very much in the news these days. Congressman N asserts that the way to solve the problem is simply to compute the tax on half of a married couple's income and then double the amount so computed. The result, he points out, will then be equal to the sum of the two taxes that each of the spouses would pay if single and the "penalty" will disappear. "My object," N declares (usually to wild applause), "is to make sure that the tax law is strictly neutral in its effect on a person's decision to get married." Would N's proposal meet his declared objective? Answer: His proposal would eliminate the marriage penalty for two-earner couples, but only by increasing the marriage bonus for single-earner couples. So "strict neutrality" would still be lacking.

6. Miriam bought a bond some time ago for $100,000 which the issuing company had a right to call (that is, redeem) at any time prior to maturity for a premium of $10,000. Interest rates having fallen this year, the bond issuer in fact exercised its call privilege and has paid Miriam $110,000 in exchange for the bond. At the same time Miriam leased certain real property she owns to a commercial tenant. Rents having fallen, the tenant offered to pay Miriam $10,000 if she would agree to cancel the lease. Miriam did agree and has received $10,000 from the tenant, which promptly vacated the leased premises. Miriam's accountant now tells her that the $10,000 bond premium will be a long-term capital gain, but the $10,000 received on the lease cancellation will be ordinary income. Miriam asks you to explain why the two $10,000 payments are treated differently. Do. Answer: Oh, just because. The Supreme Court in the Hort case treated the lease cancellation as a sale of a carved-out interest probably mistakenly), while the redemption of a bond is treated as a disposition of the "underlying" property. Seems illogical since both transactions entail the return of Miriam's principal (cash, real property) plus a premium, and hence should be treated alike.

7. Gerald until recently was employed by General Motors as a sales manager. Gerald's 5-year employment contract obligated GM to purchase Gerald's personal residence for an amount not less than Gerald's cost for such residence in the event that GM should decide to let Gerald go at the end of the 5-year term, assuming Gerald wished to move elsewhere. And that is just what GM decided. Gerald bought his home for $100,000 but the best offer Gerald (who was eager to relocate) could get for it on the market was $90,000. Accordingly, and pursuant to its contract obligation, GM bought the house from Gerald for $100,000. Prices then fell still further and, having listed the house with a real estate broker for more than a year, GM finally managed to sell the house for only $75,000. How should Gerald and GM report these events for tax purposes? Answer: Gerald has compensation income of $10,000 (though, of course, no loss, the house being a personal asset), while GM has an ordinary salary expense in the same amount and a basis for the house of $90,000. The $15,000 resale loss? Could be just a capital loss (chance fluctuation of the housing market); could be ordinary under § 1231 (real property used in the trade or business); could be ordinary under Corn Products/Arkansas Best (an expense of terminating Gerald's employment, kind of like a severance cost). Probably a capital loss a la the dissent in Bagley & Sewell. 8. Baxter is a second-year law student at NYU Law School. A San Francisco law firm offers to fly Baxter out to San Francisco for the purpose of a job interview. Baxter makes the trip and the

interview takes place, but the firm decides not to offer Baxter a job. The firm does, however, reimburse Baxter's transportation costs - air fare and taxis - in the amount of $1,200. Must Baxter include the reimbursement in his gross income? Explain (briefly) Answer: Don't know. The reimbursement can't be deducted as a travel expense, because Baxter doesn't have a "trade or business" to be away from; nor would it be excluded under § 132, because Baxter isn't an "employee." Still, hard to believe the Service would regard the reimbursement as gross income under § 61. But it might.

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