FEDERAL INCOME TAXATION

L6256y

Final Examination - May 1995

Professor Chirelstein

Time Allowed - THREE H ours

This examination consists of three pages.

Check now to see that your exam has all the pages.

ANSWERS MUST BE WRITTEN IN INK OR TYPEWRITTEN.

IF YOU ARE A CANDIDATE FOR GRADUATION IN MAY, 1995, WRITE ON THE COVER
OF YOUR ANSW ER BOOK (OR, IF TYPEW RITTEN, AT THE T OP OF YOUR FIRST PAGE ),
"CANDIDA TE FOR GR ADUATIO N IN MAY, 199 5."

Instructions:

This is a limited open-book examination. You may bring with you to the examination room
your Code and Regulations volume, but nothing else.

The examin ation consists of four equa lly weighted questio ns. Answer each of the m.
Explain yourself as necessary, but say no more than you need to. Irrelevant discussion earns a mark-
down. Please, please write legibly.

________________________________________

I.

Rupert is planning to make a gift to his daughter, Brangwen, of: (i) 1,000 shares of X
Corporation stock which cost him $30 a share and are now worth $70 a share, but which are pledged
to secure a loan of $45,000 which Rupert recently obtained from a local bank; and (ii) a seaside
vacation cottage which has an adjusted basis in Rupert's hands of $50,000, is worth $80,000, and is
subject to a mortgage of $30,000. Brangwen will receive the X stock subject to the bank loan and
will likewise assume Rupert's obligation for the mortgage when she takes title to the vacation
cottage.

Brangwen herself needs cash for various reasons, and she intends to sell both the X stock and
the vacation cottage almost immediately after receiving the gifts from Rupert. She has tentatively
identified buyers for both properties and will presumably sell each for its present market value.
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Rupert wants to kno w whether he ha s any federal incom e tax consequenc es to worry about.
If so, he may decline to make the gifts.

Brangwen, who is eager to receive the properties, also wants to know what her income tax
position will be.

Give them your best advice.

II.

For convenience, and because it makes calculation simpler, please assume for purposes of
this question that the topm ost tax rate for individua l taxpayers is 50%. (I know the top rate is lower
now, but 50% is easier to work with than the current rate.) Then consider the following problem:

Lobbyists for the Association of Rare Wine Merchants have been pressing Congress to
amend the Internal Revenue Code to give the "industry" they represent a special tax break. The
special break would take the form of a reduced rate of tax on the profits realized from the sale of rare
wines -- so-called Classic vintages. Merchants pay a high price for such wines and then, typically,
hold their purchases fo r an extended perio d while waiting for the wine fanciers' mark et to appreciate.
To illustrate, a Merchant might pay $1,000 for a bottle of Burgundy, vintage 1928. On average, the
bottle would be retained and stored for 5 years and then sold at retail for twice the original cost, or
$2,000. Under the present tax law, the $1000 outlay in Year 1 has to be treated as a capital
expenditure. When finally sold for $2000 in Year 5, the Merchant reports his $1000 gain ($2000 -
$1000) as ordinary income and pays tax on such gain at the regular rate (again, assume for
convenience a rate of 50%).

The lobbyists have been urging Congress to reduce the tax on rare wine profits to a flat 25%,
on the ground that holding goods for such a lengthy period involves extraordinary risk to the
Merchant (and on the further ground that rare vintage wine is a vital national resource). But the
Treasury strongly opposes that concession. As a compromise, and instead of a rate reduction, one
member of the House Ways & Means Committee has suggested that the present law should be
amended to allow the initial acquisition cost of the wine (e.g., $1000 in Year 1) to be deducted by
the Merchant as a current expense rather than having to be capitalized. The Committee member
thinks that such a com promise might b e acceptable to the Treasury, though he isn't certain.

The Association lobbyists are lukewarm towards the Committee member's proposal and
some doubt that it is really worth fighting for. Unsure about the overall effect, they now ask you for
an analysis of what they would be getting under the "current expense compromise" and what they
would be giving up if they drop the rate-reduction effort. What is your response?

III.

Farmer Brown owns 100 acres of farmland on which he grows alfalfa. A drive-in theatre
was built on the adjoining property last year, and owing to the grading and paving of the drive-in
parking area, a stream of dirty water began draining across Brown's alfalfa field, making it
impossible for Brown to plant a full alfalfa crop. As a result, Brown's net profits for the year were
reduced from $30,000 to $20,000. Brown promptly sued the drive-in company, demanding damages
of $10,000 plus an injunction against any further drainage. The drive-in company, having
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considered what it would cost to remedy the problem, has offered Brown $60,000 for a perpetual
right to drain the water across his property. Brown would have to discontinue his lawsuit if he
should accept. Brown's cost for the farmland happens to be exactly $60,000.

Needing cash to p ay off various loans, Brow n is tempted to say ye s to the drive-in's offer.
Before accepting, however, he would like to know what his federal income tax position will be if he
does.

Tell him.

IV.

Miriam is the income beneficiary of a trust created under her deceased father's will. Under
the terms of the trust, Miriam is to receive the income for 15 years. At the end of that period the
trust is to terminate and the trust principal is to be paid over to Miriam herself. In effect, Miriam is
both the income beneficiary of the trust and the remainderman. Evidently, her father wished to keep
the trust principal intact until Miriam got 15 years older. Trust principal consists of a $100,000
Treasury bond; trust income is approximately $7,000 a year.

Twelve years have passed since the creation of the trust. Miriam now makes a gift to her
adult daughter, Clara, of the right to receive the annual trust income for the 3 years that remain of the
income interest, but Miriam retains her right as remainderman to receive the trust principal at the end
of the 15-year term when the trust will terminate. Clara, needing cash, promptly sells the 3-year
income right to Baxter, an unrelated investor, for $17,000.

What are the income tax consequences of these events to each of the individuals named in
the preceding paragraph?

END OF EXAMINATION