FEDERAL INCOME TAXATION

L6256y

Final Examination -- May, 1997

Professor Chirelstein

Time Allowed -- Three Hours

This examination consists of four pages.

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

ANSWERS MUST BE LEGIBLY WRITTEN IN INK OR TYPEWRITTEN.

IF YOU ARE A CANDIDATE FOR GRADUATION IN MAY, 1997, WRITE ON THE

COVER OF YOUR FIRST ANSWER BOOK (OR, IF TYPEWRITTEN, AT THE TOP
OF YOUR FIRST PAGE), "CANDIDATE FOR GRADUATION IN MAY, 1997."

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.

Answer each of the following equally weighted questions --

there are four -- in sufficient detail to convey your reasoning
as well as your calculations, but please use no more space than
is really necessary. And please, please write legibly.

*****************************

QUESTION I

Eustacia, an acquaintance of yours, has been looking through

her recent tax returns and is somewhat puzzled by what she has
discovered. In each of the three years mentioned below, Eustacia
received $15,000 from a particular payor in connection with
property for which she herself had a cost-basis of $15,000. Yet
the tax consequences in each year proved to be different. She
wonders why. Thus:

(1) In 1993, Eustacia leased to a parking-lot operator

a tract of vacant land which she had purchased for $15,000 many
years before. The lease was for 5 years and Eustacia received a
lump-sum rental payment from the lessee of exactly $15,000. In
preparing her return, Eustacia's accountant included the entire
$15,000 in her gross income.
 (2) In 1994, Eustacia partly sold and partly gave 1,000
shares of X stock to Columbia University, her favorite charity.
The stock was worth $25,000, but Eustacia sold it to Columbia for
only $15,000, which was exactly what she had paid for it some
years earlier. Eustacia properly took a deduction of $10,000
($25,000 - $15,000) for her charitable contribution, but also
reported $6,000 of capital gain on the sale element. A brief
note from her accountant informed Eustacia that the $6,000
taxable gain was mandated by Code § 1011(b) and Regs. § 1.1011-
2(c), Example (1).

(3) In 1995, Eustacia partly sold and partly gave 1,000

shares of Y stock to her adult nephew, Clym. The Y stock was
also worth $25,000 and had also been purchased by Eustacia for
$15,000 at an earlier time. Clym paid Eustacia $15,000 for the
stock. Eustacia reported no gain or loss from the transaction
with Clym. Once more, a note from her accountant advised
Eustacia that Regs. § 1.1001-1(e), Example (3), provided the
relevant legal authority.

Assured that the returns were correctly prepared (indeed,

each return was audited by the IRS and found to be correct),
Eustacia asks you to explain why the three outcomes differ from
one another and to say whether you regard the differences as
justified given the present structure of our tax system. What's
your answer?

QUESTION II

Henchard bought a movie theatre in the suburban Town of Z

some years ago at a cost of $1,000,000, paying the seller all
cash for the property. He properly deducted depreciation of
$300,000 during the period of his ownership. Last year the Town
amended its code of fire-safety regulations to require that movie
theatres widen their aisles by 3 feet and attach floor-
illuminating lights to the aisle seats. Henchard figured he
would need $150,000 to cover the cost of these changes and
borrowed that amount from a local bank. The loan, payable in
installments over a period of years, was secured by a nonrecourse
mortgage on the theater. Henchard then entered into an agreement
with a contractor to tear out seats and put in lights in order to
meet the new fire code requirements. To Henchard's great
satisfaction, the entire cost of the work, which was completed in
due course, came to only $95,000.

Instead of paying the contractor's bill, however, Henchard

promptly sold the movie theatre to Farfrae, an up-and-coming
businessman, receiving $965,000 in cash. The bank mortgage -- to
which the property remained subject -- had been reduced to
$145,000 at the time of the sale. Finally, Farfrae assumed, and
promptly paid, Henchard's $95,000 debt to the contractor.

Henchard and Farfrae both ask you where they stand, federal
income tax-wise. Advise them (both).

QUESTION III

Arabella was slightly injured in an auto accident last year

and filed suit against the other driver for $10,000 damages. She
actually expected to settle for considerably less. Arabella also
owed a debt of $1,500 to Jude, a stone mason, for work Jude had
done on Arabella's patio. Having no ready cash and Jude’s bill
being overdue, Arabella persuaded Jude to accept an assignment of
her personal injury claim in full payment for the masonry work.

A year passed, following which, to everyone's surprise, the

other driver's insurance company proposed a settlement of $7,500.
Jude (having notified the insurance company that the claim had
been assigned to him) promptly accepted. Learning of this and
feeling cheated, Arabella insisted that Jude was not entitled to
keep any more than the original $1,500. The two consulted their
lawyers.

In the end, Jude settled with Arabella by turning over to

her half the insurance company's payment, $3,750, and keeping
half for himself.

What are the tax consequences of these events to Arabella

and Jude?

QUESTION IV

Thoughtfully describing our present income tax system, a

well-known scholar recently wrote as follows:

"The income tax is a tax system that has two parts. First,
it taxes personal service income (wages, salaries, fees, etc.)
when such income is earned. Second, it taxes wealth by including
dividends, interest, rents and capital gains in gross income. If
we wished to eliminate the wealth-tax element, we could do so in
either of two ways. We could simply treat all income from
capital investment as tax exempt, and tax personal service income
only. In the alternative, we could allow all investments to be
deducted currently, and tax spending only. Either technique
would place consumers and savers on an equal footing from a tax
standpoint in the sense that the relationship between the two
would be the same as it was, or would have been, in a world
without any taxes whatever."
 An uncle of yours who has read the quoted paragraph tells
you that he doesn't quite understand it...in fact, doesn't
understand it at all. Aware that you have just completed an
excellent tax course, your uncle asks you to explain the writer's
point. "But please don't paraphrase or repeat the same words to
me," says Uncle in a hardy yet irritable tone. "Instead, give me
a simple arithmetical illustration of the writer's idea, one that
I can grasp without a lot of mental effort. I don't care what
numbers you use or even whether they're perfectly accurate. Make
your example clear and simple, and above all be brief!"

Respond as requested.

END OF EXAMINATION