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Federal Income Taxation

L6256y

Final Examination -- May 1994

Professor Chirelstein

Time Allowed: Three Hours

This examination consists of three pages. Check


now to see that your copy of the exam has all the pages.

ANSWERS MUST BE WRITTEN IN INK OR TYPED.

IF YOU ARE A CANDIDATE FOR GRADUATION IN MAY, 1994, WRITE ON THE


COVER OF YOUR ANSWER BOOK (OR, IF TYPEWRITTEN, AT THE TOP OF YOUR
FIRST PAGE), "CANDIDATE FOR GRADUATION IN MAY, 1994.”

INSTRUCTIONS:

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 exam consists of five equally weighted questions. Answer each. Note that the word “ briefly"
appears at the end of each question. Please use no more space than is really necessary, and do write legibly.

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QUESTION I

M, a world-famous law professor, brought an action for libel against Newspeak, a national magazine,
on the ground that he had been misquoted, misrepresented and hence defamed in a published interview. To
show how high-minded he is, M stated in advance that any damages he recovered would be paid over to
Columbia University, a recognized charity. Ultimately, Newspeak offered to settle M's claim for $250,000, of
which $50,000 would be treated as compensation for M's pain and suffering and $200,000 as punitive damages
for Newspeak's "carelessness” in reporting the interview. Recalling M's earlier statement, Newspeak insisted
that the entire amount be paid to Columbia. M agreed (somewhat regretfully) and in the end Newspeak issued a
check for $250,000 to Columbia University's student scholarship fund.

M asks you how, if at all, these events should be reflected on his federal income tax return. Advise him, briefly.
FEDERAL INCOME TAXATION -- Page 2 of 3

QUESTION II

Gavit is the life tenant of a sizable testamentary trust created by her deceased husband. The income of
the trust is $100,000 a year. Gavit has more money than she needs, so she gives her daughter, D, a one-half
interest in her life estate. Gavit also gives her nephew, N (a beginning law-student), a right to receive one-
fourth of her retained share of the trust income, but only for the next three years. D, who doesn't need the
money either, at least not immediately, gives her son, S (who hopes to start a business), a right to receive all of
her one-half share of the trust income, but for the next year only.

Before receiving anything from the trust, D, N and S each sells his or her beneficial interest for cash to
an unrelated investor, D for $450,000, N for $25,000, and S for $40,000.

What are the tax consequences of these events to the several taxpayers? Explain briefly.

QUESTION III

(a) A has an adjusted basis for certain property of $100,000. At a time when the fair market value of
the property is only $70,000 A sells the property to B (A's son) for $50,000. B subsequently resells the property
to C, an unrelated investor, for $75,000. Assume the property is non-depreciable (e.g., corporate stock).

How much gain or loss, if any, does B realize for tax purposes?

(b) Same facts, except that B subsequently resells the property To C for $45,000. B's gain or loss, if
any?

(c) Same facts, except that B pledges the property for a bank loan of $60,000 shortly after buying it
from A, and subsequently resells the property to C for $45,000 cash subject to the $60,000 indebtedness. B's
gain or loss, if any?

Explain your answers briefly.

QUESTION IV

Sailor Sam (as he called himself) for many years operated a little novelty shop near the waterfront. His
specialty, which sold very well to tourists, consisted of hand-made model schooners, fully rigged and with tiny
sailors on deck, which Sam somehow managed to fit inside a variety of whiskey bottles. Nobody could figure
out how Sam did this trick, and on one occasion Hasbro Corporation, a major toy manufacturer, offered Sam a
substantial sum if he would explain the process and show the company how it was done. Sam refused.
FEDERAL INCOME TAXATION -- Page 3 of 3

Last year Sam retired to Arizona ("out of the swing of the sea," as he put it) and turned his shop over to
his daughter, Lulu. Before departing, Sam sat down with Lulu and explained the ship-and-whiskey-bottle
process in complete and exhaustive detail (the process, Lulu learned, entailed 361 individual steps). Lulu
carefully wrote down everything that Sam told her and then typed up her notes to use as a manual. Sticking to
the notes as well as she could, Lulu attempted to do as Sam had done, but with little success. After a few
months, realizing that she was likely to go crazy if she continued, Lulu got in touch with Hasbro and offered to
sell the notes to the company for $50,000. Having confirmed for itself that the notes represented a complete
description of the process, Hasbro agreed to the purchase price but insisted that as part of the consideration
Sam himself must execute a covenant promising not to reveal the process to any other manufacturer. Sam
readily complied and the deal was done.

Lulu thereupon closed the shop and moved to Vermont, where she hopes to get a job as a ski-instructor.

Lulu now asks you how the transaction with Hasbro should be reported for federal income tax
purposes. Respond, briefly.

QUESTION V

Ken, who lives in New York City, has been working for the past 2 years as a licensed plumber's
apprentice. Under State law, Ken can become a licensed plumber himself either (i) by completing 5 years of
apprenticeship or (ii) by taking and passing a State-administered examination after completing 2 or more years
of apprenticeship. Ken decides to take the exam at this point and for that purpose he enrolls in a 4-week
preparatory course -- widely reputed to be the best course available -- that is given at a vocational school
located in Albany and costs $1,500. Ken takes a 4-week lease on a studio apartment in Albany, paying $200 a
week in rent, and goes on to complete the course. Ken's meals and other out~of-pocket expenses for the 4-
week period run to about $300.

Just as the course ends Ken gets a terrible case of the flu. A doctor who visits him advises Ken that he
had better stay on in the studio apartment until he recovers, so Ken extends his lease for another two weeks at
the same $200-a-week rent. Returning to New York City, finally, Ken takes and passes the licensing exam, for
which he pays a $500 fee to the licensing board. Ken at once begins to practice his trade and, fortunately, does
quite well.

Ken is now preparing his income tax return and he asks you how each of the outlays mentioned above
should be treated (and why). Advise him briefly.

END OF EXAMINATION