Income Taxation I

Fall 2003

Bogdanski

 

 

FINAL EXAMINATION -- PART TWO

(Two hours)

 

 

INSTRUCTIONS

 

This second part of the examination consists of two essay questions, each of which will be given equal weight in determin­ing grades.  Two hours will be permitted for this part.  At the end of the two hours, you must turn in both this set of essay questions and your answers in the original envelope in which this set came.

 

All answers must be entered in the bluebooks you have been provided (or, for those typing or operating com­puters, on separate sheets of plain white paper or a computer floppy disk).  No credit will be given for anything written on this set of questions.

 

Pay close attention to the final portion, or "call," of each question.  Failure to respond to the matters called for will result in a low score for the question.  On the other hand, discussion of matters outside the scope of the call of the question will not receive credit.

 

Be sure to explain as thoroughly as possible your answers to the questions posed.  Your reasoning, discussion, and analysis are often as important as any particular conclusion you reach.

 

The suggested time limit for each question is one hour.  Experience has shown that failure to budget one's time according to this limit can result in a drastic lowering of one's overall grade on this examination.

 

Unless otherwise expressly instructed, assume that all taxpayers described in the ques­tions are individuals, and that they report their income on the cash method and the calendar year for federal income tax pur­poses.  Any references to the "Code" mean the Internal Revenue Code of 1986, as amended.

 

 

 

QUESTION ONE

(One hour)

 

Emma is employed as a manager by a corporation named Company.  Company's stock is actively traded on a national stock exchange.  On February 1, 2003, Company transfers 10,000 shares of its stock to Emma in recognition of "the love that Company's customers and co-workers have for you."  On the date of the transfer, Company stock is trading on the stock exchange at a price of $15 a share.

 

Unlike the shares traded on the market, however, the shares transferred to Emma are subject to two conditions specified in the stock transfer documents.  First, if Emma leaves Company's employ before February 1, 2004, she is required to surrender the 10,000* shares back to Company for no consideration.  Second, prior to February 1, 2005, Emma is prohibited from selling or otherwise transferring the shares to anyone other than an employee of Company.

 

Emma continues working for Company through 2005.  On February 1, 2004, the price of Company stock on the exchange is $18 a share.  On February 1, 2005, the price of Company stock on the exchange is $13 a share.  On July 1, 2005, Emma sells her 10,000 shares to her ex-husband, Harry, for $10 a share, which is the prevailing market price for the stock on that date.

 

Emma borrows $175,000 from a bank and uses the loan proceeds, along with the $100,000 stock sale proceeds, to buy residential rental property.  Here is how the $275,000 is spent: Emma pays the seller of the property $200,000 cash, and her real estate agent a $10,000 cash commission.  Shortly  thereafter, Emma spends $15,000 to make a number of overdue repairs to the property; and another $50,000 to make long-range improvements to the property.  Emma then rents the property out to strangers at a market rent.  She is able to make all her payments of principal and interest on the bank loan out of the rents.

 

What are the federal income tax consequences to Emma of each of the transactions just described, with and without all available elections?  Be sure to discuss the amount, timing, and character (ordinary or capital) of each item of income, gain, deduction, loss, or credit, and Emma's basis in her assets, at each stage of the transactions discussed.

 

Discuss.

 

(End of Question 1)

 

*  In the actual exam, there was a typographical error, and "1,000" appeared here, while "10,000" was intended.  – JB

 

 

 

 

 

QUESTION TWO

(One hour)

 

Heather and Bob have lived together as a couple for several years, but they are not married and they have no children.  Heather is a hotel worker who earns an annual salary of around $40,000.  Bob is a self-employed software developer whose business generates an annual profit of around $32,000.  Both have ambitions to increase their income greatly in future years.  For now, Heather and Bob rent their house from a landlord.  Neither Heather nor Bob itemizes his or her deductions for federal income tax purposes.  The two of them come to you, a tax lawyer, and ask you what the federal income tax consequences would be of their getting married and buying a home.

 

On her birthday, Bob gives Heather an antique fur coat that Bob received as a bequest in the will of his late grandmother.  The grandmother had purchased the coat when it was new for $50; when she died, it was worth $100.  (The grandmother was not wealthy, and her estate paid no estate taxes.)  Heather does not like the coat, but she finds a buyer who likes it a great deal.  The buyer pays Heather $225 for the coat.

 

Bob is still paying interest on his educational loans from his days as an undergraduate college student.  In 2003, he pays interest of $4,000 on the student loans, which are not secured by a mortgage or security interest on any property.

 

Also in 2003, Bob purchases about $8,000 worth of equipment and $2,000 worth of supplies for use in his business.  He pays state sales taxes of $700 on these items.

 

What are the federal income tax consequences to Heather and Bob of each of the transactions just described, with and without all available elections?  Be sure to discuss the amount, timing, and character (ordinary or capital) of each item of income, gain, deduction, loss, or credit, and Heather's and Bob's basis in their assets, at each stage of the transactions discussed.

 

Explain.

 

(End of examination)