^FEDERAL INCOME TAlt ; ection 2 ' * Final Examinations / Professor Charles Davenport INSTRUCTIONS

Transcription

1 ^FEDERAL INCOME TAlt ; ection 2 EXAMINATION ' * s / Time: 4 HOURS INSTRUCTIONS 1. This examination consists of 19 pages including the instruction page. Please count all pages before beginning to ensure that you have a complete exam. 2. This examination is "OPEN BOOK." There is no restriction on the materials you may bring in or consult while writing the examination. You may not consult with one another. You may not have a computer. 3. There are two questions. The first is a question requiring a written answer. The second is a series of questions requiring an answer of true or false. On the Scantron sheet provided to you, a mark in the a column indicates the statement is true and a mark in the b column indicates that the statement is false. Suggested times are two hours for the question requiring a written answer and one hour for the true/false questions. These times total only to three hours, and the papers will be graded with those relative weights, but you are allowed four hours to complete the examination. 4. DO NOT CALCULATE ANY PHASE-OUT PROVISIONS OF THE INTERNAL REVENUE CODE. IF YOU THINK ONE RELEVANT, YOU MAY MENTION IT. DO NOTHING MORE WITH IT. THE PHASE-OUT OF PERSONAL EXEMPTIONS AND ITEMIZED DEDUCTIONS SHOULD BE IGNORED AND NOT MENTIONED. 5. ALL EXAMINATION PAPERS MUST BE TURNED IN AT THE END OF THE EXAM. DO NOT DISCUSS THIS EXAMINATION WITH OTHERS UNTIL DECEMBER 19,2003. THERE MAY BE SOME SUPERFICIAL OVERLAP WITH AN EXAMINATION TO BE GIVEN ON DECEMBER 18,2003. YOU COULD EASILY MISLEAD THE PERSONS TAKING THAT EXAMINATION. 6. You may finish the examination early. DO NOT go back over the examination and add irrelevant material with the thought that it will help your grade. It will detract unless your additions are pertinent to the questions. 7. Your answers should show an understanding of the facts and a recognition of the issues involved. Your answer should demonstrate knowledge of the principles of law, and it should be organized as well. 8. There is limited space on the exam for you to answer the question. It should be sufficient if you organize your answer and write concisely. If you need more space, write on the back of the pages of the examination. 9. Unless the facts state otherwise, all taxpayers use the cash method of accounting and report their income on the calendar year. Do not compute any taxes. 10. All of the facts occur in 2003 unless some other year is explicitly stated. Some of the questions have facts about other years, and you will be expected to respond to those facts. The tax law in all cases, whatever the year, is the law you studied this fall. The question requiring a written answer is an adaptation of reality TV shows and a read of an article about the tax consequences of reality shows. Some facts have been changed or added to make coherent questions. END OF INSTRUCTIONS EXAMINATION BEGINS ON NEXT PAGE

2 FEDERAL INCOME TAX - Section 2 Page 2 of 19 pages I. Late in 2002, Edgar began to think about how he could capitalize on the craze of reality shows that proliferated television. He thought a winner on one of the shows could become a big-time TV or movie star. He realized that with sufficient physical workouts, his reasonably good body would be competitive in applying for the "Catch Him" reality TV show where contestants compete to remain on the show in competition for cash awards given to the winner (maximum award of $1,000,000 for a full winner). He joined the New York Sports Club at the cost of $1,500, and began training under a personal trainer who cost $200 per session, and he had 50 sessions before the end of 2002 at a total cost of $10,000. In January 2003, he knew that he was ready, and he went to Los Angeles by plane after purchasing a round trip ticket for $1,400 that was $400 cheaper than the one-way ticket of $1,800. He stayed at the Biltmore Hotel in downtown Los Angeles at the cost of $1,000 a week during his three week stay. Edgar was not a big eater, and he spent only $750 on meals during the three weeks traveling to and staying in Los Angeles. He auditioned for the "Catch Him" show but was turned down and recommended to tryout for the "Her or the Money," an all male reality show. He was chosen as a contestant on this show. The taping of the show took place within a few days, but it is aired over 12- week period although only 10 of the episodes were contests. The other two were background. Under the rules, contestants were successively eliminated until just one of them remained. A successful contestant accumulated awards at the rate of $100,000 each week, and a successful contestant could leave the game and take his awards with him at any time. The final successful contestant had to choose whether to take the $1,000,000 cash price or compete for the hand of the winner of the "Him and the Money," another reality show on the same network. Under the rules of "Him and the Money", female contestants we successively eliminated until only one remained. Under the rules for this show, they accumulated cash awards that would be awarded only if the winner on the male show chose to date the female rather than accept the cash awards accumulated by the male. The female could refuse the offer, and the male contestant would lose all of the cash award if rejected. The female contestants were not told the amount of cash that they would receive, and it was paid without any conditions at the completion of taping. The awards on "Him and the Money" doubled if the winner of that show and the winner of "Her or the Money" married within six months of the end of the taping of the show, but the awards would be paid only if the TV network was permitted to tape and exhibit the wedding. This doubling was not known to the participant, and its existence was expected to be kept secret and revealed only when the contestants were prepared to be married. Edgar learned of this arrangement by taking the show's producer out to drinks, salting the drinks with sodium pentathol (truth serum for which he paid $1,000 from an illegal vendor because he could not purchase this drug legally), and questioning the producer about the "Him and the Money.". Later, when the producer realized what had happened and threatened Edgar with telling the story to the producer's employer and blowing Edgar's plan to win the hand of the winner of "Him and the Money," Edgar paid the producer $50,000 to buy successfully the producer's silence. QUESTION I continues on next page

3 FEDERAL INCOME TAX - Section 2 Page 3 of 19 pages I. (continues) Edgar was the winner on "Her or the Money" every week for 10 weeks when he had accumulated $1,000,000 in cash awards. His winning was not a surprise to Edgar because each week he paid other contestants to vote for elimination of what Edgar thought was the strongest competition until in the final week he was pitted against the weakest competition on the show. In head to head competition with that contestant, Edgar won. He paid a total of $100,000 to these other contestants to buy their votes, but he thought that well worth his winning the option between $1,000,000 cash and the opportunity to meet the winner of "Him and the Money." Thelma had followed a path much like Edgar's although she was already in the body-building business and took no workouts that would not have been necessitated by her job. She was selected as a participant on "Him and the Money." She lived in Los Angeles where attendance at the daily taping sessions cost her only $200 for cab fares from her home to the studio on all of the days that taping occupied. At the cost of $300, she took a cab from the studio to the body-building salon where she worked, and then she took a cab home after her work session at a cost of $150 for the 12 days of taping. Thelma too won on her show. At the time she won her award totaled $3,000,000 and some "in-kind" prizes, and Edgar learned of this amount through the same producer. This was paid to her only after she had agreed to date Edgar, had accepted his proposal, and married him, although the studio's obligation to pay that amount to her did not depend on these events. But Thelma still did not know the amount. Edgar's offer of a date was eagerly accepted, led to a whirlwind romance, a proposal, and a marriage within two months of the close of the taping. At the time of the proposal, Edgar knew that Thelma would win an additional $3,000,000 if they married, and he thought that he could get a sizable portion of that from Thelma or in a divorce dissolution. He was right. Little time expired before Thelma wanted to be rid of Edgar (an attitude that he had known that he could induce because he had paid $30,000 for a psychological profile of her by a psychologist who, at Edgar's hiring, had watched her during the taping of "Him and the Money), and she had only $4,000,000 left after paying taxes on her winnings. She settled with Edgar for $2,000,000 that she paid within 30 days of the settlement agreement. Edgar's dating, romancing, and marriage required that he remain in Los Angeles for that period and until the divorce. In total this ran from February, 2003, through November, 2003, at a cost of $20,000 for an apartment, $10,000 for meals, and $25,000 romancing Thelma. These costs were in addition to the amounts set out in the second paragraph of this fact situation where Edgar's costs during the taping were set forth. One of the other prizes received by Thelma was a block of 500 tickets (face value of $ 100 per seat or $50,000 in total) with any one ticket being good for admission to any performance in the Richard Rodgers Theater on Broadway during the two years following the close of taping. The producer of the show offered to cash her out of these tickets by paying her $20,000 ($40 per ticket), but Thelma refused. QUESTION on next page

4 FEDERAL INCOME TAX - Section 2 Page 4 of 19 pages Instead, she transferred them to Edgar in the divorce settlement. This was in addition to the $2,000,000 settlement mentioned above. He first thought that he would simply turn the block over to a ticket broker and get 50 percent of their face value, but he offered seats to a friend and found the friend would pay 90 percent of their face value. So, he let his friends know of the tickets, and he sold several of them to his friends at 90 percent of face-enough that the ticket broker refused to buy the balance at the original offer of 50 percent. So, Edgar ran an ad in the Los Angeles Times (cost $150) and hired someone (cost $1,500) to handle the telephone for a week. Over that period, in some 224 sales, he sold 400 of the tickets and received $35,000 for them. The other 100 tickets he gave to the Purple Heart Veterans, a public charity that relies on donations for almost all of its support. Purple Heart soon sold the 100 tickets for $8,000. Edgar's plan worked beautifully, at the end of 2003, he was offered a TV contract that will pay him a $1,000,000 minimum a year for five years. The first show in the series will air in the 2004 fall season. You have two hours to write outlines of two memos-one to Edgar advising him of the tax consequences of the above facts and one to Thelma advising her of the tax consequences of the foregoing. DO NOT WRITE THE MEMOS-JUST THE OUTLINES.

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17 FEDERAL INCOME TAX - Section 2 Page 17 of 19 pages H. A. Nancy owns 100 shares of stock in Corporation Zilch. These shares are capital assets in Nancy's hands. She purchased them on August 1,2002. She paid $50,000 for them. On September 1,2003, she traded the Zilch shares to Louise in exchange for 50 shares of the Nil Corporation worth $125,000. Louise had purchased the shares of Nil Corporation on May 1,2002, and paid ++$60,000 for them. 1. Because of IRC section 1031, neither Nancy nor Louise realize any gain or loss on this transaction. 2. If Nancy recognizes any gain it will be long-term capital gain. 3. Because Nancy has a net Section 1231 loss for 2003, she must be concerned that it will have to offset her long-term capital gain realized on the exchange set out above and thus the tax preference for long-term capital gain. 4. Because at the time of the exchange, Nancy knew that she had a net Section 1231 gain for the year, a good tax adviser would have advised her to put off the exchange until 2004 when the gain on the Zilch shares would not be mixed with the Section 1231 gain. 5. Dividends on the Nil Corporation shares paid on December 3, 2003, to Nancy will be treated as net capital gain for Louise's loss on the exchange will be long-term capital loss. 7. As of midnight December 31,2003, Louise incurred a casualty loss (the only one for the year) in the amount of $45,000 when her uninsured personal automobile that was never used for business or income producing purposes was flattened by a boulder rolling down the hillside into her auto. This loss will offset the capital gain (assuming that the shares of Nil Corporation that she traded away are capital assets) she realized on the exchange with Nancy. 8. In addition to the casualty loss described in 7., Louise has lived in and owned an insured house for three years when it burned in The insurer paid Louise for the loss, and the amount Louise received was $60,000 more than the basis she had for the house. This $60,000 will offset the $45,000 loss on the automobile and leave Louise with a recognized net capital gain of $15,000 from these two events. 9. The transactions in described 7. and 8. will affect the amount of gain that Louise reports on the exchange with Nancy. 10. The transactions in 7. and 8. occurred after the exchange of stock with Nancy. Had Louise known that these events would occur, she would have been well-advised (considering only tax issues and that there are no other relevant tax transactions for the year) not to make the exchange with Nancy. QUESTION II continues on next page

18 FEDERAL INCOME TAX - Section 2 Page 18 of 19 pages QUESTION I B. In 1997, Harry purchased for $50,00 a parcel of vacant land hoping that it would rise in value. In 2003, when the value had risen to $200,000, a deluge unlike any that had been seen in the area since the keeping of records for the last 160 years brought a flood that covered the parcel with sand evenly distributed over the entire parcel and reduced its value to $140, Harry's insurer paid him $60,000 for the damage. This $60,000 is taxable income. 12. The $60,000 paid by the insurer to Harry is not taxable income. 13. Harry has a gain of $10,000 from the insurer's payment. 14. After the insurer's payment, the basis for Harry's land is $50, After the insurer's payment the basis for Harry land is $ After the insurer's payment, on April 23,2003, Harry exchanged the parcel of land for an apartment building having a value of $1,000,000 but subject to an indebtedness of $860,000. Harry realized a gain of $140,000 on this exchange. 17. The gain mentioned in 16. will be unrecaptured section 1250 gain. 18. Harry may report the gain mentioned in 16. on the installment method if the insurer does not make the payment mentioned in 11. until Harry is lucky. The apartment house appreciated quickly because it was in a very hot market, and on September 30,2003, Harry traded the apartment house for another parcel of vacant land having a value of $240,000, and Harry is entirely freed from the debt of $860,000 on the apartment house. He had made not any payments on the debt. Harry will have a gain of $860,000 on this exchange. 20. On the exchange in 19., Harry will realize a gain of $100, On the exchange in 19., Harry will have to recognize a gain of $100, Harry's basis for the parcel of land received in the exchange mentioned in 19. will be $ Harry's basis for the parcel of land received in the exchange mentioned in 19. will be $860, Harry's basis for the parcel of land received in the exchange mentioned in 19. will be $100,000. QUESTION I on next page

19 FEDERAL INCOME TAX - Section 2 Page 19 of 19 pages QUESTION I 25. Harry's basis for the parcel of land received in the exchange mentioned in 19. will be $160,000. C. Georgina owns shares of stock in a Nanocorp. The shares are capital assets in her hands. She paid $100,000 for them in They are now worth $60,000. Her son, Ned, needs funds, and she is willing to give him $60,000 on July 3, Answer the following questions taking only tax considerations into account. 26. Georgina should give the Nanocorp shares to Ned, let him sell them, and then he can offset the resulting $40,000 loss against his capital gains for the years. Georgina has no capital gains for the year. year. 27. Georgina should sell the Nanocorp shares and deduct the loss from her ordinary income for the 28. The strategy outlined in 26. is better than the one described in Georgina could sell the Nanocorp shares and realize a loss of $40,000. She could then sell other appreciated capital assets until she has realized $37,000 in gains. She could then buy back the appreciated capital assets that she had just sold. The tax result would be to use the loss to offset $3,000 of her ordinary income in 2003 and raise the basis for the repurchased property to its fair market value, the amount she paid for it when she repurchased it. 30. Georgina should sell Nanocorp shares, realize the loss, and claim $3,000 of it against her ordinary income for the year and hold the balance of the loss ($37,000) as a long-term capital loss carryover to be used at the rate of $3,000 per year against ordinary income if she has no capital gains in any later year. 31. Georgina gave the Nanocorp shares to Ned. He did not sell them immediately and when the stock market rally of late 2003 came, the shares climbed to a value of $130,000. Ned sold them at that time. Ned will have a capital gain of $70, Georgina gave the Nanocorp shares to Ned. He did not sell them immediately and when the stock rally of late 2003, Ned sold them for $130,000. Ned will have a capital gain of $30, If the Nanocorp shares had risen only to $80,000, and Ned sold them in late 2003, Ned would have a short-term capital loss of $20, If the Nanocorp shares hard risen only to $85,000, and Ned sold them in late 2003, Ned would have a long-term capital loss of $15, If the shares had risen in value only to $85,000, Ned sold them in late 2003, Ned would not know what to do on his 2003 tax return. END OF EXAMINATION