QUESTIONS & ANSWERS:
Federal Income Tax
Multiple Choice and Short Answer
Questions and Answers
By
DAVID L. CAMERON
Associate Director of the Tax Program and Senior Lecturer
Northwestern University School of Law
ISBN#: 082055670X
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ABOUT THE AUTHOR
David L. Cameron is the Associate Director of the Tax Program and Senior Lecturer at
Northwestern University School of Law. Prior to joining the Northwestern faculty, he was
Professor of Law at Willamette University. He began teaching in 1990 and has taught Federal
Income Taxation, Business Entities Taxation, International Taxation, and State and Local
Taxation.
Professor Cameron is the author of several tax articles, a co-author, with Philip Postlewaite and
Thomas Kittle-Kamp, of a treatise titled Federal Income Taxation of Intellectual Properties and
Intangible Assets, and co-author, with Deborah Stark, James Durham, and Thomas White, of a
casebook on commercial real estate development titled Commercial Real Estate Transactions: A
Project and Skills Oriented Approach.
iii
PREFACE
Although most law professors sincerely believe that the course or courses they teach are the
most important in the curriculum and to one’s future as an attorney, it is undoubtedly true that
tax issues permeate all fields involving the practice of law. The percentage of all lawyers who
might classify themselves as a “tax lawyer” is small, but the percentage of lawyers who
encounter tax problems on a daily basis is great. Certainly all transactional business lawyers,
whether they specialize in such areas as corporate, real estate, or bankruptcy law, need to understand the tax implications of various alternative legal structures. Litigators too need to understand the tax implications of the remedies sought in various types of actions and how the tax
results for parties on both sides of the table might be used to negotiate a mutually acceptable settlement. Even family lawyers need to appreciate the tax implications of marriage, divorce, death,
and children.
Unfortunately, income taxation is frequently viewed as one of the most difficult courses in law
school. Students often suggest a number of reasons for this, although they often boil down to the
following four. First, students believe that tax involves numbers, and numbers necessarily involve
math. This perception presents a problem because many law students may have studiously
avoided math courses since high school and are not about to change now. It is true that tax problems frequently involve numbers. For example, the determination of the amount of a taxpayer’s
gross income, the depreciation the taxpayer is entitled to, and the annuals gain on an installment
sale. All involve the use of numbers. But, fortunately, the math that students encounter in a tax
course is limited to addition, subtraction, multiplication, and division. Indeed, the use of numbers
can be a benefit because if a student can manipulate the numbers to reach the correct answer, the
student must understand the underlying concepts. If not, our student needs to study the concepts
a bit longer.
Second, students believe that tax law is inordinately complex. It is, but probably not anymore
so than a lot of other courses in law school. The problem in tax, as in these other courses, is to
“keep your head above water,” staying with the material as it is presented in class and working to
put all of the little pieces into a bigger picture. Students also suggest frustration because of the perception that the tax law is always changing. Again, it is true that hardly a week goes by when a
report of a new tax proposal is not in the headlines. So why study tax law that might not even exist
in the near future? Fortunately, the income taxes course in law school that is the subject of this
study guide cover’s basic tax concepts that are seldom the topic of significant legislative change.
In tax law, as in most other areas of the law, the change that occurs is at the margins and not in
the core concepts.
Third, some students feel that they are at a disadvantage when compared with those students
who may have undergraduate backgrounds in business or accounting. Again, it is true that these
students may have a temporary edge because they already know the vocabulary and some of
the rules of tax. But frequently students with business and accounting backgrounds know little of
the law — the Internal Revenue Code (“the Code”), the Regulations, the judicial decisions, and the
v
vi
PREFACE
Service rulings — that serve as the basic material in a course concerned with tax law. And in tax,
as in all areas of the law, the ambiguities of the law, not the widely understood rules, are the most
important for study and discussion.
Fourth, students bring a lot of “baggage” to tax class. Law students, like most citizens, have
strong feelings about the hand of government in our pockets. Some students may believe that
current levels of taxation are too high and feel that much of the tax system is illegitimate. Others
may be more concerned with how government spends its tax revenues and whether greater or
lesser government spending is desirable. Still others may be concerned about the distribution of
the tax burden and whether higher or lower income taxpayers are paying their “fair share.”
These are undoubtedly important policy issues and have a place in a tax course. But before a
knowledgeable discussion of these issues can take place and before changes in the tax law can
be considered to effectuate policy goals, one needs an understanding of the existing law. Do not
let your normative view of what the law should be clouding your attempt to understand what
the law is.
Despite these problems, the study of income taxation is stimulating and fun. First, tax is probably the most immediately applicable course that any law student might take. Almost every student has personally confronted the income tax, if only by completing a 1040-EZ form. Second,
although few people have opinions about rules of evidence or the UCC, everyone has an opinion
about taxation. And after taking a tax course, one’s opinion is better informed by an appreciation
for the goals of and problems in structuring and administering a tax system. Finally, the tax law
is ubiquitous. Students can better appreciate the almost daily debate in the newspapers and news
magazines with a basic understanding of tax issues.
But now to work. The purpose of this book is to test your understanding of the tax law and to
assist you in preparing for a tax examination. Although you can learn something from reading the
questions and answers presented, this book is not intended to provide a comprehensive explanation of tax concepts in the same nature as a casebook or hornbook. Consequently, this book should
be used only as a supplement to class materials.
The structure of this book follows the taxing formula, the same structure that the majority of
casebooks follow. The taxing formula is a useful organizational framework in which to make
sense of the various tax concepts that you will encounter. The taxing formula is presented
below:
–
–
–
x
–
Gross Income
§ 62 Deductions
Adjusted Gross Income
Standard Deduction or Itemized Deductions
Personal Exemptions
Taxable Income
Tax Rate
Tax Liability
Tax Credits
PREFACE
vii
+ Alternative Minimum Tax
Final Tax Liability
In order to determine a taxpayer’s tax liability, one first needs to determine the taxpayer’s gross
income. Section 61 of the Code broadly defines gross income, but a number of statutorily-authorized
exclusions, such as gifts and bequests (§ 1021), exist to limit a taxpayer’s taxable gross income.
Adjusted gross income (“AGI”) is then determined by subtracting so-called “§ 62 deductions”
(because they are listed in § 62 of the Code) from gross income. Section 62 deductions generally
include expenses attributable to generating income in a trade or business. In one sense, AGI is a taxpayer’s net income available for personal purposes. A taxpayer’s AGI is important because certain
itemized deductions may be disallowed in whole or in part depending on the amount of the taxpayer’s AGI.
AGI is then reduced by either the standard deduction or the taxpayer’s itemized deductions,
whichever is greater, under § 63. Itemized deductions represent personal expenses, such as
mortgage interest (§ 163(h)), property taxes (§ 164), and charitable contributions (§ 170), that
Congress has concluded should reduce a taxpayer’s AGI in order to implement social or policy goals. AGI is also reduced by personal exemptions for the taxpayer, the taxpayer’s spouse,
and any dependants (§ 151). Personal exemptions and itemized deductions (or the standard
deduction) produce an amount of income that is effectively insulated from tax. The taxpayer’s
taxable income is the amount remaining after the taxpayer’s AGI is reduced by itemized
deductions or the standard deduction and personal exemptions. The taxable income is then
multiplied by the taxpayer’s tax rate (§ 1) to determine the taxpayer’s tax liability. Unfortunately,
the taxpayer’s tax rate is not necessarily one rate but several, each of which may be applicable to a different type of income included in taxable income, such as net capital gain and various forms of net capital gain. Finally, Congress has authorized various types of credits that
might reduce a taxpayer’s tax liability such as the earned income tax credit (§ 32), the dependent care credit (§ 21), and the Hope Scholarship and Lifetime Learning Credits (§ 25A). In
order to ensure that high income taxpayers pay an appropriate amount of tax, Congress has
also instituted an alternative minimum tax (§ 55) that may increase a taxpayer’s tax liability in
certain instances.
This book is divided into eight topics, followed by a comprehensive Practice Final Exam.
Topics 1 and 2 cover gross income and the exclusions from gross income. Topic 3 covers business
and investment deductions. Topic 4 covers personal deductions that comprise the principal types
of itemized deductions. Topics 5 and 6, Selecting the Proper Taxpayer and the Timing of Income
and Deductions, are not explicitly articulated in the taxing formula but are concepts that must be
addressed in applying the taxing formula to a particular taxpayer and for a particular taxable year.
Topic 7 covers the characterization of gains and losses which is important in determining a taxpayer’s net capital gain which may be subject to preferable tax rates. Finally, Topic 8 covers
the remaining aspects of the taxing formula, tax rates, credits, and the alternative minimum tax,
necessary to compute a taxpayer’s tax liability.
1
Throughout this book, when you see section or the section symbol (§), the author is referring to a section of the
Internal Revenue Code.
PREFACE
viii
I would like to thank the numerous students with whom I have spent countless hours both inside
and outside the classroom. Their questions and, more importantly, their willingness to expose
areas of confusion, are reflected in the questions presented in this book and hopefully will help
others to avoid similar confusion in the future.
Professor David L. Cameron
Chicago, Illinois
September 2004
TABLE OF CONTENTS
Page
ABOUT THE AUTHOR
.............................................
PREFACE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
QUESTIONS
Topic 1:
Topic 2:
Topic 3:
Topic 4:
Topic 5:
Topic 6:
Topic 7:
Topic 8:
......................................................
1
Gross Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Exclusions from Gross Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Business and Investment Deductions
..........................
Personal Deductions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Selecting the Proper Taxpayer
...............................
Timing of Income and Deductions
............................
Characterization of Gains and Losses
..........................
Computing Tax Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3
11
23
33
39
47
63
73
PRACTICE FINAL EXAM: QUESTIONS
ANSWERS
Topic 1:
Topic 2:
Topic 3:
Topic 4:
Topic 5:
Topic 6:
Topic 7:
Topic 8:
...............................
83
.......................................................
95
Gross Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Exclusions from Gross Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Business and Investment Deductions
..........................
Personal Deductions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Selecting the Proper Taxpayer
...............................
Timing of Income and Deductions
............................
Characterizations of Gains and Losses
.........................
Computing Tax Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
97
109
127
141
151
163
189
211
PRACTICE FINAL EXAM: ANSWERS
INDEX
iii
v
.................................
227
..........................................................
243
ix
QUESTIONS
1
TOPIC 1:
GROSS INCOME
QUESTIONS
1. Explain why the following sentence is false: The Sixteenth Amendment to the U.S.
Constitution allows Congress to impose an income tax.
ANSWER:
Dan works for company X and received a salary of $40,000 last year. In addition, Dan received a
$10,000 bonus for obtaining several new customer accounts. His take-home pay was only $34,000
after withholding for state and federal income taxes and social security.
2. How much must Dan include in gross income this year?
(A) $50,000
(B)
$40,000
(C)
$34,000
(D) $0
Margaret is employed as a software engineer. Margaret received a salary of $75,000 last year.
Because of the labor shortage for engineers like Margaret, she is allowed to live in an employerprovided apartment free of charge. Assume that the fair market value of renting the apartment for
one year is $18,000. In addition, Margaret received a car from her employer with a fair market
value of $20,000 but that was worth only $12,000 to Margaret.
3. How much must Margaret include in gross income this year?
(A) $75,000
(B)
$92,000
(C)
$105,000
(D) $113,000
Jane, an employee with ACME Corp., received stock in the corporation on February 1 of Year 1
when it had a fair market value of $10,000. By the end of the year, the value of the stock had
increased in value to $18,000.
4. How much must Jane include in gross income and what is her basis in the stock?
(A) $10,000 of income and $0 basis
(B)
$10,000 of income and $10,000 basis
(C)
$18,000 of income and $10,000 basis
(D) $18,000 of income and $18,000 basis
3
4
QUESTIONS & ANSWERS: FEDERAL INCOME TAX
John purchased Greenacre, a parcel of unimproved real property for $10,000 in Year 1. At the end
of Year 1, Greenacre has appreciated in value to $15,000. In Year 2, John sells Greenacre to Mary
for $15,000 in cash.
5. What are the tax implications for John in Year 2?
(A) $15,000 of gain realized
(B)
$10,000 of gain realized
(C)
$5,000 of gain realized
(D) No gain realized
6. What would the tax implications in Question 5 have been if, instead of selling the property for $15,000 in cash in Year 2, John transferred Greenacre to Chris in exchange for
Blackacre? Blackacre is also worth $15,000.
(A) $15,000 of gain realized
(B)
$10,000 of gain realized
(C)
$5,000 of gain realized
(D) No gain realized
7. Now assume that Blackacre had a value of $20,000 when John received Blackacre in
exchange for Greenacre in Year 2. What will the basis of Blackacre be in John’s hands
following the exchange?
(A) $0
(B)
$10,000
(C)
$15,000
(D) $20,000
At the beginning of Year 1, Andrea purchased Blackacre for $10,000 using $1,000 of her own
money and borrowing $9,000 from a bank. The loan was secured by Blackacre and required
annual payments of interest only. The $9,000 loan was to be repaid in full at the end of Year 5. In
Year 3, when Blackacre had increased in value to $30,000, Andrea borrowed an additional
$15,000 on terms similar to the original loan. Both loans were recourse to Andrea. At the beginning of Year 5, Andrea sold Blackacre for cash in the amount of $35,000, paying off the two loans
of $24,000 from the sale proceeds.
8. Is Andrea taxed on the receipt of the loan proceeds in either Year 1 or Year 3?
ANSWER:
9. In Question 8, what is Andrea’s basis in Blackacre at the time of the sale in Year 5?
(A) $1,000, the amount she paid for the property from her own pocket
(B)
$10,000, the amount she paid for the property from her own pocket plus the $9,000
first loan
GROSS INCOME
(C)
5
$25,000, the amount she paid for the property from her own pocket plus the amount
of the two loans
(D) $30,000, the value of the property when she obtained the second loan
10. In Question 8, what is Andrea’s gain on the sale in Year 5?
(A) $1,000, the amount of the sale price in excess of the two loans minus her $10,000
basis
(B)
$10,000, the amount of the sale price in excess of the second loan minus her $10,000
basis
(C)
$16,000, the amount of the sale price in excess of the first loan minus her $10,000 basis
(D) $25,000, the amount of the sale price minus her $10,000 basis
11. Describe the difference between a recourse and a nonrecourse loan. Would the answers
in Questions 8, 9, and 10, have been any different if the loans were nonrecourse instead
of recourse?
ANSWER:
Last year, Susan acquired an office building from the seller of the property by transferring $25,000
in cash and a nonrecourse note in the amount of $1,975,000, secured by a mortgage of the office
building. The note is for a term of 15 years and requires payments of interest only during the term.
At the end of 15 years, the principal amount of the loan is due. At the same time, the seller leased
the property from Susan for a 15-year term. Under the terms of the lease, the seller will pay all maintenance costs, real estate taxes, and insurance premiums and will pay Susan rent each year which is
roughly equal to the amount of interest Susan owes the seller under the note; thus, no money will
actually change hands. Susan expects to treat the annual rent as income each year and deduct interest and depreciation. The fair market value of the property is approximately $1,000,000.
12. What is Susan’s basis in the office building for depreciation purposes?
(A) $25,000
(B)
$1,025,000
(C)
$1,000,000
(D) $2,000,000
13. If a taxpayer has a loan outstanding for $50,000 but the lender agrees to accept a onetime payment of $40,000 in complete satisfaction of the taxpayer’s obligation, does this
transaction have any effect on the taxpayer’s gross income?
ANSWER:
In Year 1, Peter borrowed $50,000 from John to begin a business. By Year 3, however, it was clear
that the business would not be successful and that Peter could not repay the loan in full. John
6
QUESTIONS & ANSWERS: FEDERAL INCOME TAX
agreed that he would accept in full payment of the loan property from Peter worth $35,000 and
services from Peter worth $10,000. Peter renders the services to John during Year 3 and transfers
the property, which he had previously purchased for $20,000, in Year 3.
14. What are the income implications to Peter from this arrangement?
(A) $5,000
(B)
$15,000
(C)
$20,000
(D) $30,000
In Year 1, Peter acquired Redacre for $25,000. In Year 6 when Redacre had increased in value to
$60,000, Peter borrowed $45,000 from a lender on a recourse basis. Peter used $10,000 of the loan
to construct improvements on Redacre and the remainder he spent on a vacation and the purchase
of a boat. The loan was secured by Redacre and required annual payments of principal and interest. The loan was to be repaid in full at the end of Year 16. By Year 10, the value of Redacre had
increased to $75,000. At the end of Year 10, Peter sold Redacre to Martha for $35,000 in cash and
Martha agreed to make the loan payments on the outstanding $40,000 balance of the loan.
15. What is Peter’s gain on the sale of Redacre?
(A) $0
(B)
$10,000
(C)
$40,000
(D) $50,000
16. In Question 14, what would the result be if, instead of increasing in value by Year 10,
Redacre declined in value to an amount less than the outstanding $40,000 balance of the
loan, Peter defaulted on the loan, and the lender foreclosed its mortgage on Redacre? At
the foreclosure sale, the lender received $38,000 for the property.
(A) $2,000 loss
(B)
$3,000 gain
(C)
$5,000 gain
(D) $3,000 gain and $2,000 discharge of indebtedness income
17. In Question 15, what would the result be if, instead of a recourse loan, the loan had been
nonrecourse?
ANSWER:
In Year 1, Penelope received a gift of stock from her grandmother. At the time of the gift, the stock
was worth $40,000, and Penelope’s grandmother had a basis in the stock of $25,000. Penelope’s
grandmother subsequently died in Year 4 when the stock was worth $55,000, and Penelope sold
the stock before the end of that year for $60,000 in cash.
GROSS INCOME
7
18. How much gain does Penelope have in Year 4?
(A) $5,000
(B)
$20,000
(C)
$35,000
(D) $60,000
19. Would the answer in Question 17 be different if, at the time Penelope received the gift
of stock from her grandmother, the stock was worth only $15,000 and Penelope subsequently sold the stock in Year 4 for $10,000 in cash? For $60,000 in cash? For $20,000
in cash?
ANSWER:
In Year 1, Marcus donated stock that he had purchased five years earlier for $10,000 to State
University, his alma mater. At the time of the transfer, the stock was worth $25,000. State paid
Marcus $15,000 for the stock.
20. How much income does Marcus have as a result of the contribution?
(A) $0
(B)
$5,000
(C)
$9,000
(D) $15,000
Gail purchased a recently constructed house from a developer in Year 1 for $100,000. In Year 2,
she discovered several defects in the house related to its construction and sued the developer. She
and the developer settled the lawsuit for $20,000, and Gail received damages in an amount equal
to the difference between the value of the house without the defects and the value of the house
with the defects. She then spent $25,000 to have the defects repaired. In Year 6, she sold the house
for $130,000.
21. How much income does she have in Years 2 and 6 as a result of the lawsuit and the sale
of the house?
(A) $0 income in Year 2 and $25,000 gain in Year 6
(B)
$0 income in Year 2 and $30,000 gain in Year 6
(C)
$20,000 income in Year 2 and $5,000 gain in Year 6
(D) $5,000 loss in Year 2 and $30,000 gain in Year 6
In Year 1, Amanda acquired a $150,000 life insurance policy on her life requiring annual premiums of $1,000. Of the entire premium, $200 represented payment toward the risk element of
the insurance policy and $800 represented payment toward the savings element of the policy. In
Year 15, Amanda surrendered the policy to the insurance company for its then cash value of
$17,500.
8
QUESTIONS & ANSWERS: FEDERAL INCOME TAX
22. How much income, if any, does Amanda have on the surrender of the policy?
(A) $0, because the sale involved a life insurance policy
(B)
$2,500
(C)
$5,500
(D) $14,500
Philip is a real estate agent for Fidelity Realtors who receives a commission equal to 70 percent
of the commission paid Fidelity of any transaction in which he is involved. This year, he purchased a $500,000 piece of waterfront property in which he acted as his own agent through
Fidelity. The $25,000 broker’s commission paid by the seller was split 50-50 between the seller’s
real estate agent and Fidelity, and Fidelity paid Philip $8,750 (70 percent of $12,500) as it would
on any other transaction in which Philip was involved.
23. What are the tax implications for Philip?
(A) Philip has no income and takes a basis in the property of $491,250
(B)
Philip has no income and takes a basis in the property of $500,000
(C)
Philip has income of $8,750 and takes a basis in the property of $491,250
(D) Philip has income of $8,750 and takes a basis in the property of $500,000
Yolanda is an attorney who specializes in estate planning. Rebecca is a master carpenter who
builds fine furniture and cabinetry. Yolanda is interested in building a library in her home, and
Rebecca has agreed to undertake the project. As they were talking about the project, Rebecca
revealed that she needed legal and financial planning advice in structuring a retirement plan and
in providing for her family in the event of her death. Realizing their joint needs, Yolanda agreed
to provide Rebecca with the legal services she was looking for in return for Rebecca’s work to
build the library.
24. Explain the tax implications of this arrangement for both Yolanda and Rebecca.
ANSWER:
Abe is a buyer and seller, as well as collector, of antiques and specializes in early American art.
He frequently attends auctions, estate sales, and flea markets throughout the western part of the
country looking for objects to sell in his gallery and to add to his own personal collection. This
past year he purchased two framed maps, one of Virginia and the other of Pennsylvania, which
had been printed in 1780. Although he paid $1,000 for the maps, he knew that he could resell them
for more than $5,000 in his gallery. Fortunately for Abe, a lot of people don’t appreciate the real
value of some items that may have been in their families for many years. More surprisingly, when
he was cleaning the frames and examining the maps, he discovered that on the back of the wood
panel holding the map of Virginia in its frame was actually a painting by an early American artist
whose work was exceedingly rare. Because the painting had been covered for years, the work was
in excellent condition. Abe estimates that the painting by itself is worth more than $15,000.
GROSS INCOME
9
25. What are the income implications of Abe’s purchase and discovery?
ANSWER:
In 2003, Mary had $8,500 withheld from her paycheck to pay state income taxes. On April 15,
2004, when filing her federal tax return for 2003, Mary itemized her deductions because the
$8,500 that she paid in state income taxes plus the deductions that she was entitled to for home
mortgage interest, municipal property taxes, and charitable contributions exceeded the applicable
standard deduction for 2003 by more than $12,000. At the same time, Mary also filed her state
income tax return which indicated that she would receive a refund of $1,300 because the amount
of withholding from her paycheck exceeded the amount of state income tax that she was required
to pay. Subsequently in June, Mary received a $1,300 refund check from the state.
26. How much, if any, of the state tax refund must Mary include in gross income?
(A) $0, because a state tax refund is not a form of gross income
(B)
$0, provided the state tax refund does not exceed the standard deduction to which
Mary was entitled for 2003
(C)
$1,300, because the state tax refund was previously withheld from Mary’s paycheck
and, thus, represents compensation for services
(D) $1,300, because the refund is inconsistent with Mary’s deduction of $8,500 in state
income taxes for 2003
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ANSWERS
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TOPIC 1:
GROSS INCOME
ANSWERS
1.
The sentence is false because Congress has always had the authority to impose an
income tax under its Article I power to “lay and collect Taxes, Duties, Imposts and
Excises.” U.S. Const., art. I., sec. 9, cl. 4. The problem prior to the enactment of the
Sixteenth Amendment was that the Supreme Court had concluded in Pollock v.
Farmers’ Loan & Trust Co., 157 U.S. 429 (1895), overr’d by South Carolina v. Baker,
485 U.S. 505 (1988), that an income tax was a direct tax requiring apportionment among
the states in accordance with each state’s population. This decision created administrative problems in structuring an income tax that would satisfy the apportionment requirement. The Sixteenth Amendment by its terms states that “[t]he Congress shall have
power to lay and collect taxes on incomes, from whatever source derived, without
apportionment among the several States, and without regard to any census or enumeration.”
U. S. Const., amend. XVI. Thus, the previously existing power of Congress to tax
income is no longer encumbered by the apportionment requirement.
2.
Answer (A) is correct. Section 61 states that compensation for services must be
included in gross income. Dan’s total compensation was $ 50,000 even though he only
received $ 34,000 in take-home pay. Answer (B) is incorrect because a bonus is treated
as compensation for services in addition to a taxpayer’s annual salary. See Treas. Reg.
§ 1.61-2(a) (referring to bonuses (including Christmas bonuses)). Although some students might equate the bonus with a gift excludable under § 102(a), § 102(c) generally
prohibits the treatment of any transfer between an employer and employee as a gift.
Answer (C) is incorrect because the $ 16,000 in state and federal income taxes and
social security withholding was paid by Dan’s employer on Dan’s behalf and, thus,
represents compensation for services. Although some tax protesters have argued that
compensation for services is not income, the Code explicitly states otherwise.
Consequently, Answer (D) is incorrect as well.
3.
Answer (D) is correct because it includes the value of all cash, property, and services
that Margaret received from her employer. Section 61 requires that gross income include
compensation for services regardless of whether the compensation is received in the
form of cash, services, or property. Answer (A) is incorrect because $ 75,000 represents only Margaret’s salary and not the additional benefits received from her employer.
Answer (B) is incorrect. Answer (B) represents Margaret’s salary plus the value of the
employer-provided apartment but does not include the value of the car. Importantly, the
Regulations provide that the value of any compensation paid other than in cash must be
the fair market value of the services or property received. Treas. Reg. § 1.61-2(d)(1).
Answer (C) is incorrect because the value of the car is included in gross income at
Margaret’s subjective valuation and not its objective fair market value.
97
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4.
Answer (B) is correct. Under § 61, gross income includes compensation paid for services whether paid in the form of cash or property. Treas. Reg. § 1.61-1(a). Therefore,
for Year 1, Jane must include the fair market value of the stock received on February 1,
$10,000, in gross income as compensation for services. Although the stock appreciated
in value from the time that she received it to the end of the year, this appreciation does
not represent compensation for services. Consequently, Answers (C) and (D) are
incorrect. The next question is Jane’s basis in the stock upon receipt. Because she paid
nothing for the stock, she might be said to have a basis of $0 in the stock. This result,
however, would create a problem if she sold the stock by the end of the year for its fair
market value of $18,000. In that case, she would have gain from dealings in property of
$18,000 (i.e., an amount realized of $18,000 minus her basis of $0) plus $10,000 of
income in the form of compensation for services for total income in Year 1 of $28,000
when all she received was stock worth $10,000 that had appreciated to $18,000. To
resolve this potential problem, the Regulations provide that the basis of property
received for compensation is equal to the amount includable in gross income. Treas.
Reg. § 1.61-2(d)(2). Jane will include $10,000 in gross income as compensation for services and take a basis in the stock of $10,000. Thus, Answer (A) is incorrect and
Answer (B) is correct. Jane will not be taxed on the appreciation in the value of the
stock until she disposes of the stock sometime in the future. If she sold the stock on
January 2 of Year 2 for its then fair market value of $18,000, she would have $8,000 of
gain, properly accounting for the full economic value of the stock.
5.
Answer (C) is correct. When John purchased Greenacre in Year 1, he received a cost
basis in the property of $10,000 under § 1012. John need not include in income the
$5,000 of appreciation that occurred over the course of Year 1 because no realization
event (i.e., a sale or other disposition of the property) by the end of Year 1. Because the
sale of the property in Year 2 was a realization event, §1001(a) requires that John realize gain in the amount by which the “amount realized” (i.e., the amount of any money
and the fair market value of any property received) exceeds the adjusted basis of the
property. Consequently, Answer (A) is incorrect because $15,000 is equal to the
amount realized and not John’s gain with respect to the property. Similarly, Answer (B)
is incorrect because it does not reflect a reduction in the amount realized by the full
amount of John’s basis in the property. Answer (C) is correct because the amount realized on the sale of the property, $15,000, minus John’s adjusted basis of $10,000 equals
$5,000 of gain, which under § 61(a)(3) must be included in gross income. This taxable
gain of $5,000 represents the actual economic appreciation in the value of the
Greenacre. Finally, Answer (D) is incorrect. Although at the time of the sale of Greenacre,
John has simply converted an asset, Greenacre, worth $15,000 into cash of $15,000, and
thus is no wealthier after the sale than before, the $5,000 of appreciation that occurred
during Year 1 was not included in John’s income because no realization event had
occurred by the end of Year 1. Thus, the taxation of the appreciation that had occurred
in Year 1 was postponed until Year 2 when the realization event occurred.
6.
Answer (C) is correct. The fact that John received Blackacre instead of cash in
exchange for the transfer of Greenacre will make no difference in the determination of
realized gain under § 1001. The amount realized under § 1001(b) is defined as the “sum
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of any money received plus the fair market value of the property (other than money)
received.” Thus, the amount realized, the fair market value of Blackacre, is $15,000. As
in Problem 4, the amount realized on the exchange of the property, $15,000, minus
John’s adjusted basis of $10,000 equals $5,000 of gain, which under § 61(a)(3) must be
included in gross income. Answers (A) and (B) are incorrect for the reasons stated in
the answer to Question 5. If Greenacre and Blackacre are like-kind property, the $5,000
of gain realized on the exchange may not be recognized, and thus not included in gross
income, under § 1031. To be included in gross income gain must be both “realized” and
“recognized.” Under § 1001(c), realized gain is recognized unless another section of the
Code, such as § 1031, applies. However, without more information, we cannot determine whether the requirements of § 1031 have been satisfied. In any event, Answer (D)
is incorrect even if § 1031 applies because $5,000 of gain would be realized on the
exchange of Greenacre for Blackacre although § 1031 may permit the gain to go unrecognized. Be sure to keep the concepts of realization and recognition separate.
7.
Answer (D) is correct. In Year 2, John will realize $10,000 of gain from the exchange
of Greenacre for Blackacre. The amount realized on the exchange of the property,
$20,000, minus John’s adjusted basis of $10,000 equals $10,000 of gain, which is recognized under § 1001(c) and included in gross income under § 61(a)(3). The question
now asks for John’s basis in Blackacre. Answer (A) is incorrect because John has
incurred a cost in obtaining Blackacre in the form of Greenacre. Consequently, a $0
basis is incorrect. Answer (B) is also incorrect because $10,000 is John’s basis in
Greenacre. We might expect Blackacre to have a basis of $10,000 if John had not recognized the gain realized on the exchange of Greenacre for Blackacre under § 1031,
for example. In such a situation, a basis of only $10,000 thereby would preserve the
gain inherent in Greenacre in Blackacre for eventual realization and recognition at a
later date. The problem, however, is determining John’s cost under § 1012 in obtaining
Blackacre and, thus, his basis in Blackacre. An argument could be made that John’s
cost was only $15,000 because that represents the fair market value of Greenacre at the
time of the exchange. However, that answer presents a problem because if John sold
Blackacre immediately following the exchange for its fair market value of $20,000,
John would have $5,000 of additional gain. John then would have a total of $15,000 of
taxable gain in Year 2, $10,000 of gain from the exchange and $5,000 of gain from the
subsequent sale of Blackacre, when John received only $10,000 of actual economic
benefit as a result of the exchange and eventual sale of Blackacre. Answer (C) is
incorrect although it would appear to be required by the language of § 1012. In
Philadelphia Amusement Park Co. v. United States, 126 F. Supp. 184 (Ct. Cl. 1954),
the court recognized this problem and concluded that the term “cost” for purposes of
§ 1012 must be the fair market value of the property received in an exchange. In this
case, the basis of Blackacre in John’s hands following the exchange is $20,000, the fair
market value of Blackacre. Thus, Answer (D) is correct. This result makes sense
because the fair market value of the property received will be equal to John’s basis in
Greenacre plus the amount of gain realized on the exchange of Greenacre for
Blackacre. Under this approach, if John sold Blackacre immediately following the
exchange for its fair market value of $20,000, there would be no additional gain. Thus,
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John would have a total gain of $10,000 in Year 2, representing the $10,000 of actual
economic benefit that John received.
8.
Although Andrea received $9,000 of loan proceeds in Year 1 when she purchased
Blackacre, these proceeds are not included in gross income because she has an obligation to repay the loan. Thus, there has been no increase in her wealth that would require
an income inclusion. The same is true in Year 3 when Andrea obtained the loan proceeds
of $15,000. Although the loan proceeds exceeded her basis in the property at the time,
the subsequent financing was not a realization event requiring the determination of gain
or loss. Again, because she had an obligation to repay the loan in the future, there was
no increase in her wealth that would require an income inclusion.
9.
Answer (B) is correct. A taxpayer’s basis in property includes the amount of any
financing incurred in acquiring the property. Effectively, the taxpayer is given credit
for basis purposes for the loan payments that will be made in future years.
Consequently, when Andrea purchased the property in Year 1, her basis was equal to
$10,000, the $1,000 that she paid from her own pocket plus the amount of the first
loan. Thus, Answer (A) is incorrect. The subsequent financing of the property in
Year 3 does not affect the basis of the property. Although Andrea obtained loan proceeds of $15,000, which exceeded her basis in the property at the time, the subsequent
financing is not a realization event requiring the determination of gain or loss. Thus,
Answer (C) is incorrect. Answer (D) is also incorrect because the fair market
value of the property at the time of the subsequent refinancing is irrelevant to the
determination of basis.
10.
Answer (D) is correct. Section 1001(a) provides that the gain realized on the sale of
property is the amount by which the “amount realized” (i.e., the amount of any money
and the fair market value of any property received) exceeds the adjusted basis of the
property. In this case, the amount realized was $35,000 and the basis of the property was
$10,000, resulting in gain of $25,000. This approach equates the tax treatment of a taxpayer who pays cash for property and the taxpayer who finances her acquisition through
borrowing. Answers (A), (B), and (C) are incorrect because they each reduce the
amount realized by the taxpayer by one or both of the amounts of the two outstanding
loans. The amount of the first loan should not reduce the amount realized because the
first loan was included in the taxpayer’s basis. To reduce the amount realized by the
amount of the first loan would allow a “double counting” of the first loan. Similarly,
because the second loan was not included in income at the time that loan was obtained,
it should not reduce the amount realized upon sale of the property. Gain of $25,000 also
accords with the economics of the taxpayer’s relationship with the property. Andrea purchased the property for $10,000 and sold it for $35,000. Taxable gain of $25,000 represents the actual appreciation in the value of the property while Andrea held it. Similarly,
if one looks only at Andrea’s out-of-pocket cost to obtain the property, $1,000, and compare that to what Andrea received while holding the property, $26,000 ($15,000 in loan
proceeds from the financing in Year 3 plus $11,000 net sales proceeds ($35,000 sales
proceeds minus the loan payoff amount of $24,000)), she is better off by $25,000 as a
result of her investment in the Blackacre.
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11.
A recourse loan is a loan that allows the lender to look to the borrower’s other assets if
the value of the property securing the loan is not sufficient to allow the lender to recover
the amount of the loan from the sale of the property should the borrower default. A nonrecourse loan is a loan in which the lender is limited to the value of the property securing the loan to recover the amount of the loan from the sale of the property should the
borrower default. Thus, from the lender’s perspective, a nonrecourse loan is more risky
than a recourse loan. A lender will lend money on a nonrecourse basis when it is confident that the net income generated by the property in the form of rents in excess of
expenses will be sufficient to cover the loan payments (principal and interest) or the
value of the property will be sufficient to repay the loan if the former assumption turns
out to be wrong. If nonrecourse loans had been involved in the previous questions, the
answers would not have changed. In Woodsam Associates v. Commissioner, 198 F.2d
357 (2d Cir. 1952), the question arose whether the refinancing of property with a nonrecourse loan in excess of the property’s basis constituted a taxable disposition of the
property. Interestingly, the taxpayer made this argument because she was looking to
increase the basis of the property by the excess of the loan amount over the basis of the
property at the time of the refinancing. The taxpayer maintained that because the loan
was nonrecourse and she was not personally liable to repay the loan, the refinancing
should be viewed as a taxable disposition of the property. The court rejected this argument stating that the refinancing did not make the lender a cotenant with the taxpayer
and, thus, no disposition of the property occurred.
12.
Answer (A) is correct. The use of seller-provided nonrecourse debt in the acquisition
of property presents the opportunity for abuse by creating incentives for the buyer and
seller to overstate the acquisition price of the property in an effort to create greater tax
deductions for the buyer through interest and depreciation expenses. The courts have
attempted to police transactions in which the amount of the nonrecourse debt exceeds
the fair market value of the property and have adopted two approaches to remedy this
situation. The first approach, articulated by the Ninth Circuit in Estate of Franklin v.
Commissioner, 544 F.2d 1045 (9th Cir. 1976), ignores the nonrecourse debt in the determination of the buyer’s basis in the property. The court’s rationale is this case was that,
because the nonrecourse debt exceeded the fair market value of the property, the buyer
could not be expected to actually make payments under the loan. Therefore, the debt did
not represent a true investment in the property upon which depreciation deductions
could be based. In addition, the debt did not represent a true loan upon which interest
expenses could be based. Under this reasoning, the buyer’s basis would be limited to
any payments actually made for the property and, presumably, any principal payments
actually made under the loan. This approach has been followed by several other courts
and by the Internal Revenue Service. See, e.g., Lebowitz v. Commissioner, 917 F.2d
1314 (2d Cir. 1990); Lukens v. Commissioner, 945 F.2d 92 (5th Cir. 1991); Bergstrom v.
United States, 37 Fed. Cl. 164 (1996); Rev. Rul. 77-110, 1977-1 C.B. 58. Answer (A)
is correct. The second approach, adopted only by the Third Circuit, would allow the
buyer to include in basis only the amount of the nonrecourse debt that did not exceed
the fair market value of the property. Pleasant Summit Land Corp. v. Commissioner, 863
F.2d 263 (3d Cir. 1988). The court’s rationale for this approach was based on the fact
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that the lender under a nonrecourse debt has no incentive to foreclose on its security
interest if the taxpayer offers to pay the debt up to the value of the property. Consequently,
the buyer will treat the nonrecourse debt as real debt in an amount equal to the fair market value of the property. Because this is a minority view, Answer (B) is incorrect.
Answers (C) and (D) are incorrect for the reasons previously discussed.
13.
If a loan is discharged for less than the amount owed, the debtor must include the difference in gross income. Here the taxpayer would have to include $10,000 in his gross
income as a result of the debt being settled for less than the amount owed.
14.
Answer (D) is correct. Peter has income in several forms as a result of this arrangement
with John. First, Peter has income in the form of compensation for services in the
amount of $10,000. Second Peter has gain on the transfer of the property of $15,000
(amount realized of $35,000 minus his basis in the property of $20,000). Third, Peter
has discharge of indebtedness income of $5,000, equal to the outstanding debt amount
of $50,000 in excess of the value of the property ($35,000) and the services ($10,000)
transferred to John. Answer (A) is incorrect because it represents only the discharge of
indebtedness income. Answer (B) is incorrect because it represents only the gain on the
transfer of the property. Answer (C) is incorrect because it represents only the sum of
the discharge of indebtedness income and the gain on the transfer of the property.
Answer (D) is correct because it represents the total of the discharge of indebtedness
income, the gain on the transfer of the property, and the compensation for services.
15.
Answer (C) is correct. To determine the gain realized on the sale of property, § 1001(a)
requires that one first determine the taxpayer’s basis and the taxpayer’s adjusted basis
in the property at the time of sale. The taxpayer’s adjusted basis is her cost basis under
§ 1012 as adjusted under § 1016. See § 1011(a). Although the loan that Peter obtained
in Year 6 had no effect by itself on his basis in Redacre, the $10,000 paid to construct
improvements on the property had to be capitalized under § 263, permitting an increase
in basis under § 1016. Consequently, at the time of the sale, Peter’s adjusted basis in
Redacre was $35,000. With respect to the amount realized, when property that is
encumbered by a recourse liability is sold and the liability is assumed by the buyer, the
amount of the liability is included in the seller’s amount realized. Treas. Reg. §§ 1.10012(a)(1) & 1.1001-2(a)(4)(ii). Because Martha paid Peter $35,000 in cash and agreed to
make the loan payments on the outstanding $40,000 balance of the loan, Peter’s amount
realized is $75,000. Consequently, the amount of gain that Peter realized on the sale is
$40,000 (the amount realized of $75,000 minus the adjusted basis of $35,000). Answer (C)
is correct. Answer (A) is incorrect because it treats as the amount realized only the
cash Peter received. Answer (B) is incorrect because it treats as the amount realized
only the cash Peter received and treats as the adjusted basis only the original cost basis
in the property. Answer (D) is incorrect because it treats as the adjusted basis only the
original cost basis in the property.
16.
Answer (B) is correct. Although the Regulations under § 1001 provide that the amount
of any recourse liability is included in the seller’s amount realized, they also provide
that the amount realized on the sale of other disposition of property that secures a
recourse liability does not include amounts that would constitute discharge of indebtedness
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income under § 61(a)(12). Treas. Reg. § 1.1001-2(a)(2). Consequently, the amount realized on the sale of property subject to a recourse debt is limited to the fair market value
of the property. Under the facts as presented, the fair market value of Redacre would be
$38,000 — the amount obtained at the foreclosure sale. Thus, with a basis of $35,000
in Redacre, Peter would realize gain of $3,000 as a result of the foreclosure sale, making Answer (B) correct. Answer (A) is incorrect because it represents the difference
between the outstanding indebtedness and the amount realized. Answer (C) is incorrect because it treats as the amount realized the entire amount of the outstanding indebtedness unreduced by the amount that would otherwise represent discharge of
indebtedness income. Answer (D) is incorrect because it assumes that Peter was discharged of the $2,000 deficiency at the time of the foreclosure. Because a recourse loan
is involved, Peter remains liable for the $2,000 until such time as the remaining loan
amount is discharged by the lender. See Aizawa v. Commissioner, 99 T.C. 197 (1992).
Only at this later time will Peter have discharge of indebtedness income.
17. The Code, the Regulations and judicial decisions treat recourse and nonrecourse loans
differently when the value of the property has dropped below the amount of the outstanding indebtedness. The Regulations provide that the amount realized on the sale or
other disposition of property that secures a recourse liability does not include amounts
that would constitute discharge of indebtedness income under § 61(a)(12). Treas. Reg.
§ 1.1001-2(a)(2). This provision does not apply to the sale or other disposition of property that secures a nonrecourse liability. Instead, the full amount of the nonrecourse liability is included in the amount realized notwithstanding the fact that fair market value
of the property is less than the indebtedness. See Treas. Reg. § 1.1001-2(c) example
(8). In Crane v. Commissioner, 331 U.S. 1 (1947), the Supreme Court suggested in
footnote 37 that the amount realized on the disposition of property securing a nonrecourse liability where the fair market value of the property was less than the indebtedness might be limited to the fair market value of the property. However, in
Commissioner v. Tufts, 461 U.S. 300 (1983), the Court rejected this idea and deferred
to the regulations providing that the amount realized in such a situation included the
full amount of the indebtedness. Congress effectively codified the Tufts decision by
enacting § 7701(g) which provides that “in determining the amount of gain or
loss . . . with respect to any property, the fair market value of such property shall be
treated as being not less than the amount of any nonrecourse debt to which such property
is subject.”
18.
Answer (C) is correct. Penelope has an amount realized in Year 4 of $60,000 under
§ 1001(b). The question requires a determination of Penelope’s basis in the stock in
order to calculate the gain realized on the sale. Because gifts of property are excluded
from gross income under § 102, Penelope might be thought to have a basis in the stock
equal to its fair market value of $40,000 at the time of the gift. This approach would
result in a gain of $20,000, the amount of appreciation that occurred in the value of the
stock while it was held by Penelope. Alternatively, because Penelope received the stock
as a gift and thereby incurred no cost in obtaining the stock, she might be thought to
have a basis of $0 under § 1012. This approach would result in gain of $60,000 on the
sale of the stock. However, the basis of property acquired by gift is not equal to its fair
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market value at the time of the gift or determined under the general rule of § 1012, but
under the special gift basis rule of § 1015. Consequently, Answers (B) and (D) are
incorrect. Section 1015 generally provides that the basis of a gift is equal to the donor’s
basis at the time of the gift. § 1015(a). In this case, Penelope’s basis would be a “carryover basis” of $25,000, equal to the basis of the stock in the hands of her grandmother
at the time of the gift. This approach results in gain of $35,000 at the time of the sale in
Year 4. Answer (C) is correct. This gain is equal to the appreciation of the stock in her
grandmother’s hands as well as in Penelope’s hands. The Supreme Court upheld the
basis rules under § 1015 against a constitutional challenge in Taft v. Bowers, 278 U.S.
470 (1929). Had Penelope received the stock through inheritance or bequest in Year 4
rather than as a gift in Year 1, the basis of the stock would have been equal to its fair
market value at the time of her grandmother’s death, $55,000, under § 1014. In that
case, Penelope would have realized $5,000 of gain upon the sale of the stock. Answer (A)
is incorrect because it is based on the basis rules applicable to inheritances or bequests
under § 1014 rather than the gift basis rules of § 1015.
19.
Section 1015 provides that if property received by gift has a fair market value less than
the donor’s basis at the time of the gift, the property has a basis for loss purposes equal
to its fair market value and a basis for gain purposes equal to the donor’s basis.
Consequently, if Penelope sold the stock for $10,000 in Year 4, she would have a loss
of $5,000, an amount equal to the amount realized of $10,000 minus the basis for loss
purposes of $15,000 (i.e., the fair market value of the property at the time of the gift).
In essence, § 1015 prevents a donor from transferring a loss to the donee that is inherent in the property at the time of the gift. Alternatively, if Penelope sold the stock for
$60,000 in Year 4, she would have a gain of $35,000, an amount equal to the amount
realized of $60,000 minus the basis for gain purposes of $25,000 (i.e., the donor’s basis
in the property). If Penelope sold the stock for $20,000 in Year 4, she would have neither gain nor loss. Using the basis for loss purposes of $15,000, Penelope would have a
gain of $5,000. Using the basis for gain purposes of $25,000, Penelope would have a loss
of $5,000. Consequently, if Penelope sells the stock for any amount between $15,000
and $25,000, there are no tax implications for her on the sale.
20.
Answer (C) is correct. Marcus has a cost basis in the stock of $10,000 under § 1012.
Although Marcus is contributing the stock to State University for less than its fair market value, the transfer still constitutes a realization event for which gain may be realized.
Consequently, Answer (A) is incorrect. Answer (D) is also incorrect because it
assumes that the amount realized is equal to the full fair market value of the property
when the amount realized on the transfer is limited to the amount of money or property
actually received for the property. In a typical part sale/part gift transaction, the donor
realizes gain to the extent that the amount realized exceeds the donor’s basis in the contributed property. Treas. Reg. § 1.1001-1(e). If this were a typical part sale/part gift, as
for example, if Marcus transferred the stock to his daughter for $10,000, Marcus would
have gain of $5,000 equal to the amount realized, $15,000, minus his basis in the stock,
$10,000. Because this is not a typical part sale/part gift, Answer (B) is incorrect.
Answer (C) is correct. In a bargain sale to a charitable organization, § 1011(b) requires
that the basis of the transferred property be apportioned between the sale portion of the
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transferred property and the contributed portion of the transferred property. The basis of
the transferred property apportioned to the sale portion is equal to the total basis of the
property times the amount paid for the property divided by the fair market value of the
property. In this situation, the amount paid for the property was $15,000 and the fair
market value of the property was $25,000. Consequently, 15,000/25,000 or 3/5 of the
total basis of the stock is attributable to the sale portion of the transfer, resulting in a
basis for the sale portion of the stock of $6,000 ($10,000 times $15,000/$25,000). Thus,
Marcus realized a gain of $9,000 equal to the amount realized, $15,000, minus the basis
of the sale portion of the stock of $6,000.
21.
Answer (A) is correct. When Gail received the settlement of $20,000, it represented a
recovery of her investment in the property. Consequently, it did not constitute income
in Year 2. Answer (C) is incorrect. In addition, she did not realize a loss in Year 2 even
though she spent $5,000 more than the amount she received from the developer to settle the lawsuit. Answer (D) is also incorrect. Although the $20,000 settlement represented a recovery of her investment in the property, and thus did not constitute income,
it did serve to reduce her basis in the property to $80,000. Thereafter, when she spent
$25,000 to repair the defects in the house, Gail was required to capitalize these costs
under § 1016, thereby increasing her basis in the house to $105,000. Consequently,
when she sold the house in Year 6, her adjusted basis was $105,000 rather than the original cost basis of $100,000. Thus, Gail realized $25,000 of gain in Year 6, equal to the
amount realized, $130,000, minus the adjusted basis, $105,000. Answer (A) is correct.
Answer (B) is incorrect because it uses the original cost basis of the house to determine
the amount of gain on its sale. From an economic perspective, Gail spent $105,000
while holding the house (the original $100,000 purchase price minus the $20,000 settlement amount plus the $25,000 cost to correct the defects) and sold the house for
$130,000, resulting in a net benefit of $25,000. Interestingly, Answers (A), (C), and (D)
all result in net income of $25,000 to Gail for tax purposes and, thus, properly account
for the net economic benefit that she received. However, only Answer (A) properly
applies the provisions of the Code.
22.
Answer (A) is incorrect because the exclusion from gross income for proceeds
received under a life insurance policy applies only when the proceeds are paid by reason of the death of the insured. § 101(a)(1). Instead, § 72(e) requires that the cash value
of the policy in excess of the taxpayer’s investment in the policy be included in gross
income. The problem that arises, however, is the determination of the taxpayer’s investment in the policy. Certainly, Amanda paid $15,000 in premiums over the course of the
15-year period that she held the policy. However, of the total premiums, $3,000 represented payment toward the risk element of the insurance policy and $12,000 represented
payment toward the savings element of the policy. The cash value of the policy represented the value of the savings element of the policy. This would suggest that only the
$12,000 portion of the premiums paid toward the savings element of the policy should
be treated as her investment in the policy. The $3,000 portion of the premiums paid
toward the risk element of the policy should be treated as a nondeductible personal
expense incurred in buying insurance coverage over the 15-year period. Nevertheless,
§ 72(e)(6) treats the aggregate amount of premiums paid for the policy as the taxpayer’s
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investment in the contract. Consequently, Amanda has $2,500 of income from the sale
of the insurance policy. Answer (B) is correct. This result effectively allows Amanda
to deduct an otherwise nondeductible personal expense. Although conceptually correct,
Answer (C) is incorrect under § 72 of the Code. Answer (D) is incorrect because it
treats as Amanda’s investment in the policy only the portion of the total premiums paid
toward the risk element of the insurance policy.
23. Answer (D) is correct. This transaction could be viewed in two different ways. First,
Philip could be viewed as performing services for himself and purchasing the property
for only $491,250 ($500,000 purchase price minus the $8,750 commission he received)
because the commission he received represents money he paid the seller that was
returned to him via Fidelity. In this situation, if he subsequently sold the property for its
fair market value of $500,000, he would have gain of $8,750 in the year of the sale.
Alternatively, he could be viewed as performing services and being compensated for
those services, as if he wore one hat as broker for himself, and purchasing the property
for $500,000, as if he wore a separate hat as the buyer of the property. In this situation,
he would have income in the form of compensation for services in the current year and,
if he subsequently sold the property for its fair market value of $500,000, he would have
no gain in the year of the sale. Consequently, the only difference between these different views is when Philip has income and the type of income involved. The first view is
reflected in Answer (A) and the second view is reflected in Answer (D). Although a
taxpayer is typically not taxable on the value of services that he performs for himself
(which is often referred to as imputed income), the Fifth Circuit in Commissioner v.
Daehler, 281 F.2d 823 (5th Cir. 1960), concluded on facts substantially similar to
those in this hypothetical that the taxpayer received income in the form of compensation for services as a result of the employer/employee relationship. If Philip is
attributed with income in the form of compensation for services, he should be treated
as acquiring the property with a basis equal to its fair market value. Answer (D) is
correct. Although it could be viewed as conceptually correct, Answer (A) is incorrect in light of the decision in Daehler. Answer (B) is incorrect because it attributes
no income to Philip in either the current year or the year of a subsequent sale. Answer
(C) is incorrect because it attributes income to Philip in both the current year and in
the year of a subsequent sale.
24.
Yolanda is clearly performing services for Rebecca and receiving compensation for her
services in the form of services rendered by Rebecca. Similarly, Rebecca is performing
services for Yolanda and receiving compensation for her services in the form of services
rendered by Yolanda. Section 61 includes in the definition of gross income compensation for services. The Regulations under § 61 specifically recognize that compensation
for the rendition of services may take the form of the receipt of services, in which case
“the fair market value of such other services taken in payment must be included in
income as compensation.” Treas. Reg. § 1.61-2(d)(1). See also Rev. Rul. 79-24, 1979-1
C.B. 60 (requiring that the fair market value of services received in exchange for services rendered must be included in gross income). Not all exchanges of services (or of
goods for services or of goods for goods) will give rise to gross income, however. If
the parties involved are family members or friends, the rendition of services may be
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properly characterized as a gift, the value of which would be excluded from gross
income under § 102. However, the initial rendition of services or of goods must not be
conditioned on the subsequent rendition of services or of goods or a gift will not be
deemed to exist. See Commissioner v. Duberstein, 363 U.S. 278 (1960) (a gift for purposes of § 102 arises only when property is transferred “out of affection, respect, admiration, charity or like impulses” or as a result of the transferor’s “detached and
disinterested generosity”). In this situation, Yolanda’s rendition of services appears to be
a quid pro quo for Rebecca’s rendition of services and, thus, the exclusion for gifts
under § 102 will not be applicable.
25.
Typically, a bargain-purchase in which the purchaser of property in an arm’s length
transaction acquires the property for less than its fair market value does not give rise to
gross income. See Geeseman v. Commissioner, 38 B. T. A. 258 (1938). In this situation,
Abe’s acquisition of the two maps that he purchased for $1,000, but that he knew he
could sell for $5,000, does not give rise to gross income until he sells the maps sometime in the future. He will have a cost basis in the maps of $1,000 under § 1012 so that,
when he sells them for $5,000 in the future, he will have $4,000 gross income (amount
realized, $5,000, minus his adjusted basis, $1,000) at that time. The discovery of the
painting presents a somewhat different question, however. The Regulations under § 61
provide that treasure trove constitutes gross income for the taxable year in which it is
reduced to undisputed possession. Treas. Reg. § 1.61-14(a). In Cesarini v. United States,
296 F. Supp. 3 (N.D. Ohio 1969), aff’d per curiam, 428 F.2d 812 (6th Cir. 1970), a taxpayer who found $4,467 in cash in a piano purchased for $15 was deemed to have gross
income in an amount equal to the cash in the year it was reduced to the taxpayer’s undisputed possession under Ohio law. Assuming that the painting is in Abe’s undisputed
possession under state law, a similar analysis could be used to attribute $15,000 of
income to Abe. Nevertheless, the facts in Cesarini are distinguishable from the facts
involving Abe because Abe did not discover cash, but a painting. Although the
Regulations under § 61 do not limit treasure trove to cash, Abe could argue that the bargain purchase rules should apply, requiring the allocation of his $1,000 cost basis in the
items acquired among the two maps and the painting, and that any recognition of
income in connection with the painting should await its subsequent sale.
26.
Answer (D) is correct. The first thing to appreciate in answering this question is that
on her 2003 federal income tax return, Mary was entitled to deduct the full $8,500 in
state income taxes withheld from her paycheck during 2003. This is true despite the fact
that, when she filed her federal return in April of 2004, she may have known that she
was going to receive a refund of a portion of the amount that was withheld from her paycheck for state income tax purposes. Under the tax benefit rule, however, Mary’s recovery of the $1,300 that was withheld from her income and refunded to her in 2004 must
be included in her gross income because the recovery is inconsistent with her having
taken a deduction on her 2003 federal income tax return for the $8,500 in state income
taxes withheld. Consequently, Answer (D) is correct. Under § 111, Mary would not be
required to include any portion of the refund in gross income if the prior deduction of
state income taxes did not yield her a tax benefit. See Question 63. In this situation,
however, the itemized deductions that she took on her 2003 federal income tax return
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exceeded the standard deduction that she was otherwise entitled to by more than $1,300,
so the full amount of the refund in 2004 did result in a tax benefit in 2003 (i.e., a lower
taxable income for 2003). Answers (A) and (C) are incorrect because the answer to
this question does not depend on whether or not the refund itself is gross income. Mary’s
only income was in the form of compensation for services which is clearly a form of
gross income. Had Mary not itemized her deductions in 2003 and deducted the full
amount of the state income taxes withheld from her paycheck in 2003, she would not
have to treat the refund as gross income because receipt of the refund would not be
inconsistent with a prior deduction. Answer (B) is incorrect because the amount of the
refund as compared to the standard deduction to which Mary was entitled in 2003 is
irrelevant.