Federal Tax exam: sample answers Spring, 1999

1. Last year Ursula won $1,000 playing the horses but lost $600 shooting craps at an AtlanticCity casino. Also last year, Ursula sold her diamond ring for $600 more than it cost her but soldher fur coat for $1,000 less than it cost her. As a consequence of all this, Ursula's accountant toldUrsula that $1,000 must be added to her gross income for the year. Is the accountant right?Explain (briefly).

Answer: Right. Though personal gambling losses ($600) can be offset against gambling gains($1,000). No offset against the gain from the ring sale ($600) for the loss ($1,000) on the sale ofthe fur coat.

2. Suppose Father buys stock for $1,000, retains a right to receive the dividends for 10 years,and gives the remainder to Daughter. Assume the present value of Father's retained dividendright is $600. § 167(e)(1) was added to the Code in 1989 at the Treasury's insistence to deal witha significant tax “problem” arising out of the arrangement just illustrated (and certain similararrangements). What "problem" might the Treasury have been concerned about?

Answer: Stripping the remainder arguably leaves Father with a wasting asset, i.e., the 10-yeardividend right, which he would be entitled to amortize under general principles. Can't permitthat, however, when income right and remainder are held by family members: otherwiseeverybody would do it, thus rendering investment in corporate stock depreciable.

3. XYZ Insurance Co. wants to offer a new type of insurance policy under which an individualwill be insured for x% of any federal or New York State income tax deficiency found to be duefollowing an audit of the individual's tax returns by either the IRS or the State tax authoritiesprovided, among other things, that the returns were prepared by a certified public accountant).XYZ would like to advertise (truthfully) that any and all recoveries under the policy will beexempt from federal income tax. Can it do so?

Answer: State yes, federal no. Just the Old Colony case.

4. Some years ago Rupert bought a large tract of undeveloped land for $100,000, drawing theentire purchase price from his own resources. Later Rupert mortgaged the land for $75,000, themortgage being non-recourse. Rupert had made mortgage principal payments of $15,000. Thisyear Rupert sold the land to another investor subject to the unpaid mortgage principal, now$60,000, and received cash from the buyer in the amount of $65,000. How much gain or loss, ifany, will Rupert recognize on the sale?

Answer: He invested $115,000 (100 + 15) and withdrew $140,000 (75 + 65). Must have a gain of$25,000.

5. The so-called marriage penalty is very much in the news these days. Congressman N assertsthat the way to solve the problem is simply to compute the tax on half of a married couple'sincome and then double the amount so computed. The result, he points out, will then be equal tothe sum of the two taxes that each of the spouses would pay if single and the "penalty" willdisappear. "My object," N declares (usually to wild applause), "is to make sure that the tax law isstrictly neutral in its effect on a person's decision to get married." Would N's proposal meet hisdeclared objective?

Answer: His proposal would eliminate the marriage penalty for two-earner couples, but only byincreasing the marriage bonus for single-earner couples. So "strict neutrality" would still belacking.

6. Miriam bought a bond some time ago for $100,000 which the issuing company had a right tocall (that is, redeem) at any time prior to maturity for a premium of $10,000. Interest rates havingfallen this year, the bond issuer in fact exercised its call privilege and has paid Miriam $110,000in exchange for the bond. At the same time Miriam leased certain real property she owns to acommercial tenant. Rents having fallen, the tenant offered to pay Miriam $10,000 if she wouldagree to cancel the lease. Miriam did agree and has received $10,000 from the tenant, whichpromptly vacated the leased premises. Miriam's accountant now tells her that the $10,000 bondpremium will be a long-term capital gain, but the $10,000 received on the lease cancellation willbe ordinary income. Miriam asks you to explain why the two $10,000 payments are treateddifferently. Do.

Answer: Oh, just because. The Supreme Court in the Hort case treated the lease cancellation as asale of a carved-out interest probably mistakenly), while the redemption of a bond is treated as adisposition of the "underlying" property. Seems illogical since both transactions entail the returnof Miriam's principal (cash, real property) plus a premium, and hence should be treated alike.

7. Gerald until recently was employed by General Motors as a sales manager. Gerald's 5-yearemployment contract obligated GM to purchase Gerald's personal residence for an amount notless than Gerald's cost for such residence in the event that GM should decide to let Gerald go atthe end of the 5-year term, assuming Gerald wished to move elsewhere. And that is just whatGM decided. Gerald bought his home for $100,000 but the best offer Gerald (who was eager torelocate) could get for it on the market was $90,000. Accordingly, and pursuant to its contractobligation, GM bought the house from Gerald for $100,000. Prices then fell still further and,having listed the house with a real estate broker for more than a year, GM finally managed to sellthe house for only $75,000. How should Gerald and GM report these events for tax purposes?

Answer: Gerald has compensation income of $10,000 (though, of course, no loss, the housebeing a personal asset), while GM has an ordinary salary expense in the same amount and a basisfor the house of $90,000. The $15,000 resale loss? Could be just a capital loss (chancefluctuation of the housing market); could be ordinary under § 1231 (real property used in thetrade or business); could be ordinary under Corn Products/Arkansas Best (an expense ofterminating Gerald's employment, kind of like a severance cost). Probably a capital loss a la thedissent in Bagley & Sewell.8. Baxter is a second-year law student at NYU Law School. A San Francisco law firm offers tofly Baxter out to San Francisco for the purpose of a job interview. Baxter makes the trip and the

interview takes place, but the firm decides not to offer Baxter a job. The firm does, however,reimburse Baxter's transportation costs - air fare and taxis - in the amount of $1,200. Must Baxterinclude the reimbursement in his gross income? Explain (briefly)

Answer: Don't know. The reimbursement can't be deducted as a travel expense, because Baxterdoesn't have a "trade or business" to be away from; nor would it be excluded under § 132,because Baxter isn't an "employee." Still, hard to believe the Service would regard thereimbursement as gross income under § 61. But it might.