Income Taxation I

Fall 2014

Bogdanski

OVERALL EXAM INSTRUCTIONS

This examination consists of 36 multiple-choice questions (Questions 1 through 36) and two essay questions (Questions 37 and 38). An hour and a half (90 minutes) is recommended for the multiple choice questions, and two hours is recommended for the two essay questions (one hour per essay question).

In determining grades, each multiple choice question will count for 1 point, and each essay question will count for 24 points. Therefore, you should budget your time according to the allocation just given. Experience has shown that failure to budget one’s time appropriately can result in a drastic lowering of one’s overall grade on this examination.

For the multiple choice questions, you must submit your answers using SofTest. You may write the answers to the essay questions either on SofTest or by hand. If you choose to write the essay answers by hand, you must write them in the bluebook(s) you have been provided, and return the bluebook(s) along with the hard copy of the essay questions.

At the end of the exam, all students must return the hard copy of the essay questions in the envelope in which it came. However, no credit will be given for anything written on the hard copy of the essay questions. Only your electronic answer file (and bluebook(s), if any) will be graded.

For the multiple choice questions, choose the best answer to each question posed. Choose one, and only one, answer to each question. Although an incorrect answer earns no credit, there is no penalty for an incorrect answer on the multiple choice questions, so it is in your interest to answer every question, guessing if necessary.

In the essay 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. In your essays, 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.

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 37

(One hour)

Brett is a nationally known commentator on television. His adjusted gross income is $2 million a year. His employer is a broadcast television network known as The Net.

Brett’s wardrobe on his programs is supplied by The Net. After wearing any item on two separate broadcasts, Brett is allowed to, and does, take the item home and keep it for his own use.

On the advice of his agent, Brett has extensive plastic surgery performed on his face in order to make him look younger and increase the number of viewers for the television programs in which he appears. The surgery is performed by a famous cosmetic surgeon, Syd. The cost of the plastic surgery is $50,000, which Brett pays in cash in advance to Syd.

Shortly after the procedure, Brett develops an allergic reaction to a drug used in the surgery. The reaction causes Brett to miss several important broadcasts, and it requires additional medical attention, by different doctors, at a cost of $10,000. Brett also pays these expenses in cash. The Net does not pay Brett for the time he is out of work.

Brett sues Syd for damages arising out of the plastic surgery. Brett’s lawsuit contains both breach-of-contract and tort claims. The contract portion of the lawsuit alleges that the procedure did not produce the results that Syd guaranteed. The tort portion of the lawsuit alleges that Syd was negligent in prescribing the drug and failing to obtain Brett’s informed consent regarding the risks of the surgery. In the lawsuit, Brett seeks a refund of the $50,000 paid to Syd, $10,000 in reimbursement for medical expenses, $200,000 in lost wages, $500,000 for pain and suffering, and $1 million in punitive damages. After discussions that drag on for more than a year, Syd pays $300,000 to Brett in exchange for Brett’s release of all claims.

The following year, Julie negotiates a new employment contract for Brett with The Net. Under the revised agreement, half of Brett’s salary is to be paid to him each year as he earns it, and the other half is to be paid to him two years after he performs the work. Brett has no right to accelerate the payments. The Net’s obligation to make the deferred payments to Brett is secured by shares of The Net stock, which The Net pledges as collateral. The arrangement between Brett and The Net is not a qualified retirement plan.

What are the federal income tax consequences to Brett of each of the transactions and events just discussed, with and without any available elections? Be sure to discuss the amount, timing, and character (ordinary or capital) of each item of income, gain, loss, deduction, or credit, and the basis of Brett’s property, at each stage of the transactions.

Discuss.

(End of Question 37)

QUESTION 38

(One hour)

Dana is a successful clothing designer. She is self-employed in that business. The fair market value of Dana’s assets greatly exceeds her liabilities.

Dana rents her principal residence from the Lees, a wealthy couple who live in another town. The rent is $1,500 a month. Dana does all of her design and administrative work in a small converted garage in the back yard of the residence. Dana occasionally does yoga in the shed to relax after long work sessions. The garage constitutes 10 percent of the floor space that Dana rents from the Lees.

Dana has invested some of her savings in Blackacre, vacant land on the edge of the metropolitan area in which she lives. This investment has gone sour. Dana bought it two years ago for a purchase price of $300,000. Dana financed the purchase with nonrecourse debt of $270,000, borrowed from a bank. Dana used $30,000 that she withdrew from her savings and the $270,000 she borrowed from the bank to buy Blackacre. Dana has repaid $20,000 of principal on the debt, so that its outstanding balance is $250,000; however, the fair market value of Blackacre has declined to $225,000. Dana has not made any improvements to Blackacre. Dana surrenders Blackacre to the bank and notifies the bank that she will not be repaying the loan.

Dana and her husband, Harley, get a divorce. In the divorce settlement agreement, Dana agrees to pay Harley $1,200 a month “spousal support” for four years. The agreement provides that if Harley remarries during the four-year period, his right to the monthly payments from Dana shall terminate. Under the agreement, if Harley dies during the four-year period, Dana must continue making the monthly payments to whomever Harley specifies in his will. The agreement says nothing about the tax treatment of the “support” payments. Harley does not die or remarry during the four-year period, and Dana faithfully makes all of the required payments to him. There are no other transfers between Dana and Harley incident to the divorce.

Dana dies a few years later, survived by her son, Seth. Seth is Dana’s sole heir. At the time of Dana’s death, one of her customers, a manufacturing company named XYZ, owes her $5,000 for design work that she had done before she died. On the date of her death, the fair market value of this account receivable – that is, XYZ’s obligation to Dana – is $4,800. After Dana dies, XYZ contacts Seth and asks if Seth will accept a $5,000 gift card in payment of the XYZ’s debt to Dana. Seth agrees to the proposal and uses the card to obtain $5,000 worth of items at the XYZ store.

What are the federal income tax consequences to Dana and Seth of each of the transactions and events just discussed, with and without any available elections? Be sure to discuss the amount, timing, and character (ordinary or capital) of each item of income, gain, loss, deduction, or credit, and the basis of Dana’s and Seth’s property, at each stage of the transactions.

Explain.

(End of examination)

Created by: bojack@lclark.edu
Update:  21 Jan 15
Expires:  31 Aug 16