Income Taxation I

Fall 2005

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 operating com­puters, on separate sheets of plain white paper or an approved type of computer 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)

 

            Tom is the beneficiary of a trust established by the will of his mother, Martha, who died seven years ago.  The trust holds stocks in publicly traded companies.  The terms of the trust provide that the trustee may either pay the dividends to Tom every year, or accumulate them and pay them to Tom every fifth year, for the rest of Tom’s life.  At Tom’s death, the trust is to terminate and the stocks are to be distributed to Tom’s children.  The trustee in fact promptly dis­tributes all the dividends to Tom as soon as they are received.

 

            Tom is a real estate developer who regularly builds condominium projects and sells units in them to the public.  Tom sells one such unit to a customer, Connie, for $300,000 -- a $100,000 cash down payment, and an additional $20,000 a year for the next 10 years, plus interest on the unpaid balance at a market rate.  At the time the transaction closes and ownership of the unit passes to Connie, the fair market value of Connie’s promissory note, which evidences the 10 years of deferred payments, is $160,000.  The cost of the unit to Tom was $200,000.  Tom takes a mortgage back from Connie to secure her obligation to make the deferred payments.

 

            Tom runs his real estate business out of a detached building he owns out behind his personal resi­dence.  The building, once used as a garage, has been converted into a small but comfortable office and meeting space.  Tom regularly meets with clients and contractors there.  Occasionally he will have a group of friends and business contacts over to the garage for a low-stakes poker game, over which business is invariably discussed.  Tom supplies drinks and cigars at the game; the guests bring food for all to share.  Tom is not a good poker player and usually loses money in the game.

 

            What are the federal income tax consequences to Tom 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.

 

            Discuss.

 

(End of Question 1)

 

 

QUESTION TWO

(One hour)

 

            Muriel is a self-employed house painter.  On August 15, 2005, she purchases a two-year-old light general purpose truck for use in her business.  The truck costs $40,000.  It is the only equipment Muriel buys in 2005.

 

            Muriel’s 21-year-old daughter, Donna, lives with her throughout 2005 while Donna attends a local commuter college on a full-time basis.  Donna has a good job and provides more than one half of her own support.  Muriel’s husband died three years ago, and Muriel has not remarried; like Donna, Muriel supports herself.

 

            Muriel owns an apartment building that she purchased several years ago for an original cost of $550,000.  She has made improvements to the building at a cost of $50,000 over the years, and she has properly taken depreciation deductions totaling $75,000 on the improved property.  Muriel owes $540,000 to a bank on a loan secured by a nonrecourse mortgage on the building.  Property values in the neighborhood have been declining, and Muriel’s building has a fair market value of only $490,000 despite the improve­ments.  In 2005, Muriel defaults on the mortgage loan and allows the bank to foreclose on the property.  Since the loan is nonrecourse, Muriel has no further obligation to the bank.  At the time of the foreclosure, she is insolvent.  She has substantial assets besides the building, but her liabilities exceed the fair market values of those assets.

 

            What are the federal income tax consequences to Muriel in 2005 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.

 

            Explain.

 

(End of examination)

 

 

Created by: bojack@lclark.edu
Update:  17 Jan 06
Expires:  31 Aug 06