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FEDERAL INCOME TAXATION

L6256y

Final Examination -- May, 1997

Professor Chirelstein

Time Allowed -- Three Hours

This examination consists of four pages.

Check now to see that your exam has all four

pages.

ANSWERS MUST BE LEGIBLY WRITTEN IN INK OR TYPEWRITTEN.

IF YOU ARE A CANDIDATE FOR GRADUATION IN MAY, 1997, WRITE ON THE

COVER OF YOUR FIRST ANSWER BOOK (OR, IF TYPEWRITTEN, AT THE TOPOF YOUR FIRST PAGE), "CANDIDATE FOR GRADUATION IN MAY, 1997."

INSTRUCTIONS;

This is a limited open-book examination. You may bring with

you to the examination room your Code and Regulations volume, butnothing else.

Answer each of the following equally weighted questions --there are four -- in sufficient detail to convey your reasoning

as well as your calculations, but please use no more space thanis really necessary. And please, please write legibly.

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QUESTION I

Eustacia, an acquaintance of yours, has been looking throughher recent tax returns and is somewhat puzzled by what she has

discovered. In each of the three years mentioned below, Eustaciareceived $15,000 from a particular payor in connection withproperty for which she herself had a cost-basis of $15,000. Yetthe tax consequences in each year proved to be different. She

wonders why. Thus:

(1) In 1993, Eustacia leased to a parking-lot operator

a tract of vacant land which she had purchased for $15,000 manyyears before. The lease was for 5 years and Eustacia received a

lump-sum rental payment from the lessee of exactly $15,000. Inpreparing her return, Eustacia's accountant included the entire

$15,000 in her gross income.

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(2) In 1994, Eustacia partly sold and partly gave 1,000shares of X stock to Columbia University, her favorite charity.

The stock was worth $25,000, but Eustacia sold it to Columbia foronly $15,000, which was exactly what she had paid for it some

years earlier. Eustacia properly took a deduction of $10,000($25,000 - $15,000) for her charitable contribution, but alsoreported $6,000 of capital gain on the sale element. A brief

note from her accountant informed Eustacia that the $6,000taxable gain was mandated by Code 1011(b) and Regs. 1.1011-

2(c), Example (1).

(3) In 1995, Eustacia partly sold and partly gave 1,000

shares of Y stock to her adult nephew, Clym. The Y stock wasalso worth $25,000 and had also been purchased by Eustacia for

$15,000 at an earlier time. Clym paid Eustacia $15,000 for the

stock. Eustacia reported no gain or loss from the transaction

with Clym. Once more, a note from her accountant advisedEustacia that Regs. 1.1001-1(e), Example (3), provided the

relevant legal authority.

Assured that the returns were correctly prepared (indeed,each return was audited by the IRS and found to be correct),

Eustacia asks you to explain why the three outcomes differ fromone another and to say whether you regard the differences asjustified given the present structure of our tax system. What's

your answer?

QUESTION II

Henchard bought a movie theatre in the suburban Town of Zsome years ago at a cost of $1,000,000, paying the seller allcash for the property. He properly deducted depreciation of

$300,000 during the period of his ownership. Last year the Town

amended its code of fire-safety regulations to require that movietheatres widen their aisles by 3 feet and attach floor-illuminating lights to the aisle seats. Henchard figured he

would need $150,000 to cover the cost of these changes andborrowed that amount from a local bank. The loan, payable in

installments over a period of years, was secured by a nonrecoursemortgage on the theater. Henchard then entered into an agreement

with a contractor to tear out seats and put in lights in order to

meet the new fire code requirements. To Henchard's greatsatisfaction, the entire cost of the work, which was completed in

due course, came to only $95,000.

Instead of paying the contractor's bill, however, Henchardpromptly sold the movie theatre to Farfrae, an up-and-comingbusinessman, receiving $965,000 in cash. The bank mortgage -- to

which the property remained subject -- had been reduced to$145,000 at the time of the sale. Finally, Farfrae assumed, and

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promptly paid, Henchard's $95,000 debt to the contractor.

Henchard and Farfrae both ask you where they stand, federalincome tax-wise. Advise them (both).

QUESTION III

Arabella was slightly injured in an auto accident last year

and filed suit against the other driver for $10,000 damages. Sheactually expected to settle for considerably less. Arabella also

owed a debt of $1,500 to Jude, a stone mason, for work Jude haddone on Arabella's patio. Having no ready cash and Judes billbeing overdue, Arabella persuaded Jude to accept an assignment of

her personal injury claim in full payment for the masonry work.

A year passed, following which, to everyone's surprise, theother driver's insurance company proposed a settlement of $7,500.

Jude (having notified the insurance company that the claim hadbeen assigned to him) promptly accepted. Learning of this and

feeling cheated, Arabella insisted that Jude was not entitled tokeep any more than the original $1,500. The two consulted their

lawyers.

In the end, Jude settled with Arabella by turning over toher half the insurance company's payment, $3,750, and keeping

half for himself.

What are the tax consequences of these events to Arabellaand Jude?

QUESTION IV

Thoughtfully describing our present income tax system, awell-known scholar recently wrote as follows:

"The income tax is a tax system that has two parts. First,it taxes personal service income (wages, salaries, fees, etc.)when such income is earned. Second, it taxes wealth by including

dividends, interest, rents and capital gains in gross income. If

we wished to eliminate the wealth-tax element, we could do so ineither of two ways. We could simply treat all income from

capital investment as tax exempt, and tax personal service incomeonly. In the alternative, we could allow all investments to be

deducted currently, and tax spending only. Either techniquewould place consumers and savers on an equal footing from a tax

standpoint in the sense that the relationship between the twowould be the same as it was, or would have been, in a world

without any taxes whatever."

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An uncle of yours who has read the quoted paragraph tellsyou that he doesn't quite understand it...in fact, doesn't

understand it at all. Aware that you have just completed anexcellent tax course, your uncle asks you to explain the writer's

point. "But please don't paraphrase or repeat the same words tome," says Uncle in a hardy yet irritable tone. "Instead, give mea simple arithmetical illustration of the writer's idea, one that

I can grasp without a lot of mental effort. I don't care whatnumbers you use or even whether they're perfectly accurate. Make

your example clear and simple, and above all be brief!"

Respond as requested.

END OF EXAMINATION