1992 Exam

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FEDERAL TAXATION Page 1 of 4

FEDERAL INCOME TAXATION

L6256y

Professor Chirelstein

Final Examination - April 1992

Time allowed - Three Hours

This exam consists of 4 pages.

Check now to see that your copy

has all the pages.

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, istotally 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 individualemployees 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 programson 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 lowerManhattan. 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 monthsago 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

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1992 Exam