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FEDERAL INCOME TAXATION

L6256y

Professor Chirelstein

Final Examination - April 1992

Time allowed - Three Hours

This exam consists of 4 pages.


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ALL ANSWERS MUST BE WRITTEN LEGIBLY IN INK OR TYPEWRITTEN.

IF YOU ARE A CANDIDATE FOR GRADUATION IN MAY, 1992, WRITE ON THE COVER OF YOUR
ANSWER BOOK (OR, IF TYPEWRITTEN, AT THE TOP OF YOUR FIRST PAGE) "CANDIDATE FOR
GRADUATION IN MAY 1992."

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 mortgagee-
bank.

What are the tax consequences of these events to Aunt in Year 4 and to
Neph in Year 6?

II.
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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 stop-
smoking 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?

END EXAMINATION