Income Taxation I

Fall 2007

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)

 

      Betty, an engineer, is employed by a corporation, Chipco.  Betty holds options, which she received from Chipco in 2005, to purchase Chipco stock.  Under the options, which are incentive stock options as described in the Code, Betty has the right to purchase 10,000 shares of Chipco stock for $3 a share, which was the fair market value of the stock back when the options were originally granted to her.  Betty’s rights in the options have been fully vested ever since the original grant.  In 2007, Betty exercises her options in their entirety, purchasing 10,000 shares for $30,000.  At the time of the exercise, Chipco stock is trading on the public market for $6.50 a share, and so Betty’s stock has a fair market value when she receives it of $65,000.

 

      Near the end of 2007, Chipco declares and pays to all of its shareholders, including Betty, a cash dividend of 90 cents a share.  Betty receives a check from Chipco in the amount of $9,000 on December 11, 2007.  Busy with the winter holidays, she does not deposit the check into her bank account until January 3, 2008.

 

      In 2007, Betty marries Jason, who is a wealthy doctor.  The couple, who have no children, live in a state that has separate property laws (as opposed to community property laws).  Jason has been married twice before.  He persuades Betty to enter into a pre-nuptial agreement.  Pursuant to the agreement, the day after the wedding, Jason transfers to Betty a parcel of vacant beachfront property with a fair market value of $500,000.  Jason had purchased the land years ago for $275,000.  In exchange for the real estate, Betty agrees that upon any divorce, she will have no further rights to any of Jason’s property.  Betty pays a family law attorney $12,000 to represent her in connection with negotiation of the agreement and the closing of the property transfer.

 

      Betty’s salary at Chipco is based in part on the company’s income from patents on various inventions that she has developed for the company over the years.  Early in 2008, it is discovered that the company made a mistake in computing her 2007 salary, and therefore under her employment contract Betty must return $4,000 to Chipco.  She does so by writing a check for that amount a few days after the error is discovered.

 

      What are the federal income tax consequences to Betty of all the transactions just discussed, with and without any available elections?  Be sure to discuss the amount and timing of each item of income, gain, loss, deduction, or credit; the character (ordinary or capital) of each item of income, gain, loss, or deduction; and Betty’s basis in her Chipco stock and the beachfront property.

 

      Explain.

 

(End of Question 1)

 

 

QUESTION TWO

(One hour)

 

      You are approached by a client, Charles, who has questions about several federal income tax matters.  One of these involves the proceeds of some life insurance that he received when his mother, Mom, recently died.  Charles received a $100,000 lump-sum benefit by reason of Mom’s death; the premiums Mom had paid on her policy before her death totalled only $65,000.

 

      Charles also asks about some real estate that he inherited from Mom.  Mom bought the property, a mountain cabin on a large lot, decades ago when it was worth around $100,000.  At the time she died, however, the property had a fair market value of $1,000,000.  Mom had recently taken out an equity loan on the property, and at the time of her death there was a $250,000 balance outstanding on that debt.  The property is still subject to that mortgage.

 

      Charles is planning to hold onto the cabin for use as a vacation home.  He and his family and friends expect to use the place for recreation a few weekends each year, plus all of the summer months from June through August.  During the rest of the year, he is hoping to list the property with a real estate management company for rental to strangers.  Charles is hoping to use the rent to defray various expenses in connection with the property, including mortgage payments, taxes, insurance, and maintenance.  The real estate management company will also, of course, take a fee for its work.

 

      Finally, Charles also has a question about a contribution he made this year of his automobile, which he had previously used in commuting to work, going on vacations, running personal errands, and various other personal activities.  He donated it to his favorite charity, a school for troubled children.  Charles had paid $30,000 for the car originally.  When he donated it to the school, it was in good condition, and on a used car lot, it would have sold for about $12,000.  Having no need for the vehicle, however, the school sold it to a stranger over the internet for $9,500 cash, about a month after receiving it from Charles.

 

      Write a memo to Charles explaining the federal income tax consequences to Charles of the life insurance proceeds, his inheriting the cabin property, the planned use and rental of that property, and the charitable contribution of the auto.  Be sure to discuss the amount and timing of each item of income, gain, loss, deduction, or credit; the character (ordinary or capital) of each item of income, gain, loss, or deduction; and Charles’s basis in the cabin property.

 

      Discuss.

 

(End of examination)

 

 

Created by: bojack@lclark.edu
Update:  14 Jan 08
Expires:  31 Aug 08