QUESTION NO. 5
FEBRUARY 2006
OREGON BAR
EXAMINATION
Tom received his undergraduate degree in 2000 at the age of 21. As a
graduation gift, Tom’s grandfather gave Tom 2,000 shares of stock in Microspot, for
which Grandfather originally paid $10 per share. Tom graduated from law school
in May 2003, owing $100,000 in student loans. Tom was hired by the law firm of
Smith & Smith at a gross annual salary of $75,000. Smith & Smith also offered to
pay $20,000 directly to the lender on Tom’s student loan, and that payment was
made in January 2004. Also in 2004, Tom’s grandfather gave Tom a $50,000 car.
Tom wanted to pay off the $80,000 balance of his student loans in 2004, and
sold 1,000 shares of his Microspot stock for $100 per share.
65%
1.
Discuss the federal income tax consequences for Tom based on
these 2004 events.
In January 2005, Tom was involved in an auto accident that destroyed his
car. Tom was seriously injured in the accident, and his doctors advised him that it
was unlikely that he would ever again be able to practice law. Smith & Smith
terminated his employment the next day. Tom sued the other driver and received a
settlement in the amount of $45,000 for the loss of the vehicle, $1,500,000 in lost
wages, and $2,000,000 for pain and suffering. Tom received these funds in a lump
sum, which was paid to him in 2005.
35%
2.
Discuss the federal income tax consequences for Tom based on
these 2005 events.
February 2006 Oregon Bar Examination
Question No. 5 - Issue Outline and
Answer Tat Addresses All Issues
Page 1 of 3
FEBRUARY 2006
OREGON BAR EXAMINATION
QUESTION NO. 5
FEDERAL INCOME TAXATION
ISSUE OUTLINE
A.
2004 Income Tax Issues
1.
Gross Income
a. Salary
b. Payment on Loan
2.
Sale of stock
a. Basis
b. Capital Gain tax
3.
Gift of vehicle
a. Basis
b. No gain
B.
2005 Income Tax Issues
1.
Vehicle casualty loss – no tax
2.
Lost wages – ordinary income
3.
Pain and Suffering damages – excluded from income
ANSWER THAT ADDRESSES ALL ISSUES
1. 2004 Events
Salary: Gross Income is defined by the Internal Revenue Service as all income, from whatever
source derived unless excluded by the Internal Revenue Code. Per Glenshaw, income is “an
accession to wealth, clearly realized, over which the taxpayer has complete dominion and
control”. Tom’s salary of $75,000 is compensation for services rendered, and is taxable as gross
income under the Code. This is ordinary income, taxable at a maximum rate of 35%.
February 2006 Oregon Bar Examination
Question No. 5 - Issue Outline and
Answer Tat Addresses All Issues
Page 2 of 3
Payment by Tom on Student Loan: Receipt of the loan proceeds by Tom while a student was not
included in his gross income, and was not subject to tax in the years received. The portion of
Tom’s payments allocated to interest on the loan is generally deductible by Tom in the years
paid, with certain dollar limitations.
Payment by Employer on Student Loan: Smith & Smith’s payment of $20,000 on Tom’s student
loan is an economic benefit to Tom, derived from his employment, and is taxable as gross
income. As discussed below, gifts are generally excluded from gross income. However, the
code specifically provides that the transfer of property from an employer to an employee does
not qualify under the gift exclusion, and the $20,000 is included in Tom’s gross income for 2004.
However, Tom would be entitled to take a deduction for any portion of the employer’s payment
that was allocated to interest.
Gift by Grandfather of Car: Gifts are excluded from gross income, under the Code. Thus, Tom
receives the car without federal tax consequences to Tom. The adjusted basis of property
transferred by gift is the sam in the hands of the recipient as in the hands of the donor. Here,
Tom’s basis in the car is the same $50,000 basis that Grandfather had in the car, if the car had
appreciated in value; or the fair market value of the car at the time of the gift, if the car had
depreciated in value. (points given for either discussion). (The gift has gift tax implications for
Grandfather, but that is beyond the call line of this question.) Additional 5 points awarded for a
more detailed discussion of carryover basis.
Sale of Microspot Stock: As discussed above, Tom’s basis in the stock gifted to him in 2000
from his Grandfather is the same as Grandfather’s original basis of $10 per share. Sale of the
stock is a realization event. Tom will recognize capital gain of the difference between the $10
per share basis and the $100 per share selling price, or a total of $90 per share in gain. Tom sold
1,000 shares, and has capital gain of $90,000. The capital gain is long-term in that he had held
the stock for more than one year, thus enabling Tom to calculate the tax liability using the
preferred long-term capital gain rates (maximum of 15%) rather than the sort-term capital gain
rates.
2. 2005 Issues
Loss of Vehicle: Proceeds received as a result of casualty loss are excluded from gross income if
the loss exceeds $100, and if the net casualty losses in any year exceed 10% of the taxpayer’s
adjusted gross income. A casualty only arises where there is a sudden, unusual and unexpected
event. If the car had appreciated in value, then Tom’s basis was the fair market value of the car
at the time of the gift. If that fair market was less than $45,000, then the deduction would be
limited to the lesser of the sustained damage or the fair market value. If the car had depreciated
in value from the time of the gift, then because Tom received $45,000 for the loss of the vehicle,
and had a $50,000 basis in the vehicle, the $45,000 is not included in his gross income and is not
subject to tax. In addition, assuming Tom did not otherwise claim depreciation on his vehicle, he
February 2006 Oregon Bar Examination
Question No. 5 - Issue Outline and
Answer Tat Addresses All Issues
Page 3 of 3
has sustained a $5,000 long-term capital loss that may be used to offset any long-term capital
gain otherwise taxable in 2005. Capital losses are deductible only to the extent of capital gain,
and may be carried forward for use in offsetting capital gain in future years.
Lost wages: Settlement proceeds received on account of the plaintiff’s personal physical injuries
are excluded from gross income, even if they replaced lost wages. Thus, Tom’s receipt of
$1,500,000 in 2005 as replaced lost wages will be excluded from his gross income for tax
purposes.
Damages for Pain and Suffering: Amounts received to settle lawsuits for tort-like personal
injuries are excluded from gross income. Injuries from the car accident are tort-like personal
injuries, and the $2,000,000 received in 2005 for pain and suffering will be excluded from Tom’s
gross income.
Attorney Fees: If no portion of the award is taxable, there is no tax allocated to the attorney fees
paid, nor a deduction available for the payment of attorney fees. However, if any portion of the
award is subject to tax (such as a portion of the award attributed to the lost vehicle), then the
attorney fees paid would be a non-business expense deduction.