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FEDERAL INCOME TAXATION

L6256y

Final Examination -- May 1998

Professor Chirelstein

Time Allowed -- Three Hours

This examination consists of three pages. Check now to see that


your exam has all three pages.

ANSWERS MUST BE LEGIBLY WRITTEN IN INK OR TYPEWRITTEN.

IF YOU ARE A CANDIDATE FOR GRADUATION IN MAY, 1998, WRITE ON THE


COVER OF YOUR ANSWER BOOK (OR, IF TYPEWRITTEN, AT THE TOP OF YOUR
FIRST PAGE), "CANDIDATE FOR GRADUATION IN MAY, 1998."

INSTRUCTIONS:

The exam consists of three essay questions, equally weighted. Answer all of them.
You may bring to the exam your Code and Regulations volume, but nothing else. Don’t write
any more than you really need to, and please, please write legibly. If you finish early, good.

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QUESTION I

Seller Corporation owns a factory building which it uses for its manufacturing
operations. The building has a fair market value of $1 million. Having suffered losses
recently and needing cash to pay its bills, Seller has decided to sell the factory building if it can
find a purchaser willing to pay full price. Jones, an individual investor, now proposes to buy
the building from Seller on the following terms: Jones will pay Seller $750,000 cash for title to
the building, with Seller to be granted the right, for the next 2 years, to lease the property to
any third party or to continue using the building for any purpose of its own.

Seller’s original cost for the building, which it purchased 20 years ago, was $600,000.
Its adjusted basis at the present time is $200,000.

After due consideration, Seller decides to accept Buyer’s offer on the terms just
described. What will be the federal income tax consequences to both parties?
FEDERAL INCOME TAXATION -- Page 2 of 3

QUESTION II

Some years ago, Bloom, an aging bachelor, created a trust to which he transferred
government bonds having a value of $1 million. (The basis of the bonds in Bloom’s hands was
also $1 million.) Under the terms of the trust, Bloom himself was entitled to receive the trust
income for life. On Bloom’s death, the trust income was to be paid to his favorite niece,
Molly, for her life. On Molly’s death, the trust was to terminate and the principal was to be
distributed to Stephen, Bloom’s favorite nephew.

Although the trust was irrevocable, Bloom retained a power, exercisable in his sole
discretion, to amend the trust instrument so as to eliminate Molly’s secondary life estate. In
effect, Bloom could, if he wished, direct the trustee to disregard Molly’s future income interest
and advance Stephen’s remainder to the date of Bloom’s death. Originally, Bloom intended to
exercise this power only if Molly, whether through marriage or other wise, should develop
ample financial resources of her own, and he so advised Molly in writing at the time the trust
was created.

Molly and Bloom are now estranged (Molly having taken certain career steps of which
Bloom sharply disapproves). In addition, Bloom himself (now elderly) has recently suffered
severe financial reverses and needs money to pay his debts. As a result of all this, Bloom
approaches Stephen, who has become quite rich, and offers to amend the trust and eliminate
Molly’s future income interest if Stephen will pay Bloom the sum of $500,000 in cash. After
briefly calculating Bloom’s age and state of health, Stephen notifies Bloom that he is prepared
to accept Bloom’s offer.

Before the two men can act, however, Molly learns of their plan and war ns Bloom that
she will sue him for breach of fiduciary obligation if the plan is carried out. Molly concedes
that Bloom has power to terminate her future income interest under the terms of the trust but
asserts that local law bars him from exercising that power in exchange for a financial
consideration from another beneficiary, namely, Stephen. Molly also advises Stephen that she
will contest his legal right to take the trust pr operty following Bloom’s death.

Negotiations between Bloom, Molly and Stephen ensue. Finally, the three enter into an
agreement which provides, among other things, that Molly will formally waive her legal rights
as a trust beneficiary and that Bloom will pay over to Molly one-half of the amount to be
received by him from Stephen. In due course, Stephen pays Bloom $500,000. Bloom then
executes an instrument terminating Molly’s future income interest and on the same date pays
over to Molly the sum of $250, 000.
FEDERAL INCOME TAXATION -- Page 3 of 3

(a) What are the income tax consequences of these events to Bloom and Molly?
(b) What tax consequences should Stephen anticipate when the trust terminates? All
three of the parties ask you for advice.

QUESTION III

Mt. Morris Dr ive-in Theatre Co., having removed covering vegetation from its
property in or der to build ramps for automobiles, is sued by F armer Green whose neighboring
farmland is, as a result, now being inundated by the drainage of rain water, of which the
consequence is to destroy a substantial part of Farmer Green’s valuable alfalfa crop. F armer
Green complains that all this flooding will cost him roughly $150,000 over the next five years
or so, and he asks the court for equitable relief in the form of an injunction and order
compelling Mt. Morris to build a dr ainage system on its property that will divert the rain water
to a public drain. Mt. Morris, which lear ns from an engineer that such a drainage system
would cost it between $50,000 and $60,000, resists the suit.

The court, after due consideration, decides the lawsuit in favor of Mt. Morris on the
ground that the Company is not responsible for coping with rainfall problems, and it denies
Farmer Green any and all of the requested relief.

Following the court’s decision, Mt. Morris and Farmer Green enter into negotiations.
In the end, Mt. Morris agr ees to install an adequate drainage system, and F armer Green agrees
to pay Mt. Morris the sum of $75,000 when such installation has been completed.

The drainage system is promptly installed at a cost to Mt. Morris of $55,000. Farmer
Green, satisfied that his land is now protected, pays Mt. Morris $75,000 in cash, as agr eed.

What are the tax consequences of these events to both parties?

END OF EXAMINATION