Question 1 (20% of final grade)

Ralph and Doug are two old lawyers who have made argument the basis of a long and warm friendship. Last spring they got into one of their many disputes, this time about one of the finer points of the Rule Against Perpetuities. As their argument became more heated, Ralph said "I will bet you a trip to Nepal that I am right."

Doug, sure as usual of the correctness of his position, said, "You have yourself a bet. If I am right, you will pay the full cost of trip for the 2 of us to Nepal including all accommodations and guides. If you are right, which of course you are not, I will pay for the trip. What do you say?"

Ralph replied, "You have a bet. This is great! I've always wanted to go to the Himalayas. The only thing better than the trip is that you, my friend, are going to pay for it."

The point involved in their dispute was obscure, and the two finally settled on a professor at the local law school to decide who was right. Much to Ralph's chagrin, the professor after some deliberation decided that Doug had the better of the argument. Somewhat begrudgingly, particularly after some delighted gloating by Doug, Ralph contacted Bart Samuels, who ran Trekkers Limited, a company specializing in full outfitting of trips to Nepal.

After many consultations Ralph and Doug decided that they would plan to arrive in Nepal on August 1, 1995, and that Samuels would make all arrangements for transportation, accommodations, meals, special clothing and equipment for their recreational trip which would last one month. What surprised both Doug and Ralph was the cost of the trip, $25,000 each. Samuels said that his trips were without question the best in the business and well worth the price. Doug knew that Ralph was well set financially, but he felt somewhat guilty that their little argument and bet was costing Ralph so dearly.

Samuels required full payment of the fee 30 days before departure. Knowing this, Doug called Ralph in early June and said, "Ralph, I can't let you pay for this whole thing. I know a bet is a bet, but why don't you let me pay for half of my trip. I'll let you off the hook for the rest."

Ralph could afford to pay for both trips, but welcomed Doug's offer and said, "Thanks. You have a deal. I'll make it up to you someday."

Samuels also had a provision in his contract of engagement making the costs of the trip non refundable. He had to include this provision, he said, because his expenses in Nepal were non refundable to him once the arrangements were made. The only exception was if he was unable to personally guide the trip through illness or death.

Despite the risk Ralph agreed to this arrangement. At Doug's suggestion, however, Ralph bought a trip insurance policy from Acme Travel Insurance for $500. This policy provided that if they were unable to go on the trip, Ralph and Doug would be paid 90% of the cost of the trip that they forfeited. With this policy in hand the two friends sent checks to Samuels on June 15, 1995. Ralph paid $37,500 (all of his cost plus 1/2 of Doug's cost). Doug paid $12,500 (1/2 the cost of his trip).

Full of excitement the two arrived in Nepal on August 1. They checked into their hotel, a Spartan but beautiful spot, and waited for Samuels to call. When he did not for 2 days, they were worried. Finally, on the third day they received a depressing telegram. It informed them that Samuels had been killed the week before when a sudden wind blew him off a mountain trail in China. All arrangements for their trip were canceled and no refund would be given.

They stayed on in Nepal for several days anyway and did some sightseeing on their own. Finally, they decided to return home. They were disappointed but agreed that they had had a great adventure in any case. Doug said, "Maybe it wasn't all we had hoped for, but I had a wonderful time with you, friend. It was worth half the cost anyway and besides we can get most of our money back since I was so clever to suggest insurance."

When they got home and filed a claim with Acme, they received another disappointment. The company informed them that the risk covered by the insurance they purchased was only that the traveler would be unable to take or complete the trip because of physical problems of the traveler. There was no coverage for loss of a trip due to the condition of the travel provider.

Knowing that they would be better represented by an attorney not personally involved in the matter, Doug and Ralph hired Mandy Lawrence to seek whatever compensation she could get from any of the parties. After several weeks she informed them that Acme was correct, and they had no coverage for their loss under the policy. In addition, Lawrence discovered that Trekkers Limited was not a corporation but only the name used by Samuels in doing business as a sole proprietorship, and also that Samuels' estate had no assets whatsoever. They paid Lawrence's fee of $800 and chalked the whole affair up to experience.

What are the income tax consequences to Doug and Ralph arising from these facts?

Question 2 (20% of final grade)

Marlene Davis practices law in Prairie View, a town in outstate Minnesota. Her office is located on the second floor of a building which she owns. On the first floor she operates a grocery store which carries many specialty foods not available elsewhere in town or even in neighboring towns. She has always had a great interest in good cooking and loves to operate this business along with her law practice. Most of the day to day work such as stocking and cashier work is done by her employees, but Marlene does all the ordering and travels to California, New York and other areas where specialty foods are available throughout the year. She operates this business as Specialty Treats.

Over several years Marlene has done legal work for William James, an elderly man with a sizable estate. Five years ago James asked Marlene to prepare his will, and because he had no close relatives, he told her that he would like to leave the bulk of his estate to her since she had been such a good lawyer for him and he felt close to her. Knowing that it was unethical to draft a will in which someone other than a relative made a devise to her, Marlene advised William that he should find another lawyer to draft such a will. He went to a lawyer in Minneapolis and executed a will in which he gave $10,000 to each of 5 cousins who were his closest relatives. He gave the residue of his estate to Marlene.

About a year ago William came to Marlene and told her that he was very upset with the way two of his cousins, Don and Jacob Farley, were treating him. He asked Marlene to draft a codicil (amendment) to his will revoking the gifts to both of them. Marlene, without thinking carefully about it, did so. Only later did it occur to her that the revocation of the two devises increased the size of the residue passing to her. Before she did anything about it, William died with an estate of $500,000.

All of the cousins were upset when they heard that they would be getting very little of William's estate. Jacob took it worse than the others and began to tell anyone around Prairie View who would listen that Marlene was a lawyer who defrauded clients, neglected their affairs and allowed mice and rats to infest her grocery without doing anything about it. He and the rest of the cousins also brought an action contesting the will on the grounds of undue influence by Marlene on William.

After some time Marlene agreed to pay each of the cousins $50,000 to drop the legal action saying she was doing so because their action cast doubt on her ethics and damaged her business reputation. She received all of the estate after payment of these amounts.

In addition, Marlene brought a libel action against Jacob and ultimately won a judgment of $200,000. Of this, $100,000 was allocated to compensatory damages and the remainder to punitive damages specifically for the statements relating to the infestation of her grocery business by vermin. She paid lawyer's fees of $30,000 for this recovery.

In the same year she sought to deduct the expenses of her trips to California, New York and elsewhere as expenses of her grocery business. On these trips she always went on Thursday night and returned late on Sunday. She spent her time browsing in various wholesale outlets and other specialty food stores to get ideas for her store. She also ate at the best restaurants and stayed at the most luxurious hotels. Because of the nature of this business, her expenses for every year since she opened it have been in excess of her income.

On her income tax returns, Marlene has taken the following positions:

a) She has claimed a business expense deduction for the payments to the cousins and exclude the devise from her gross income.

b) She has excluded the recoveries in her libel action against Jacob and deducted the legal fees she paid in the action.

c) She has deducted all of the expenses of her grocery business including all of the travel expenses.

Do you agree with her treatment of these transactions? Explain.

Question 3 (20% of final grade)

Your client, Ray Johnson, is 85 years old and in poor health. He owns some unimproved land in northern Wisconsin worth $300,000 subject to nonrecourse debt of $400,000. He bought the property 20 years ago for $500,000 speculating that some ski resorts being developed in the vicinity might increase its value over time. He was incorrect.

He also has other assets having a value of $400,000 and a basis of $100,000. He plans to leave his entire estate to his nephew, Phillip, who has treated him better than anyone else. He expects that he will not live long.

Ray describes himself as "from the old school". He lived through the Great Depression and has always disliked debt though he understands that it is useful sometimes. He has told you that he would like to give his estate to Phillip free of debt but is not sure it makes sense from a tax standpoint to pay of the debt prior to his death. He wants to know what he should do to leave his estate to Phillip in the way best to designed to minimize the tax burdens on the family.

Specifically, Ray has asked whether he should transfer the Wisconsin property to the lender in satisfaction of the debt or to a third party subject to the debt. He also has asked whether he should sell the land and other property to raise enough money to pay off the debt and leave the rest to Phillip unencumbered.

What advice would you give to Ray?

Question 4 (4% of final grade)

Wilbur Force bought unimproved farmland in rural Olmsted County in 1965 for $50,000. He never lived on this property, but rented it for cash rent to a neighboring farmer. In 1990 he decided to move to Montana to get away from all the people in Minnesota. He found a small ranch that he wanted near the town of Two Dot, Montana and decided to buy it. He closed this transaction by paying $200,000 in cash. A few days after the closing Wilbur was talking to his lawyer friend, Danielle Waytz, about his plans to sell his Minnesota property for which he expected to get about $250,000. He expressed concern about the large tax he might have to pay, and Danielle told him that if he exchanged the property he could probably avoid much if not all of the tax.

When he told Danielle of his recent purchase of the ranch, she suggested a way to structure the disposition of his Minnesota farm to avoid tax. First, Wilbur would find a buyer for his Minnesota farm. Then, he would transfer the Montana ranch to Danielle in exchange for her promise to pay him $250,000 in cash to be paid within 30 days of closing. Danielle would enter into a purchase agreement with the prospective buyer of the Minnesota farm promising to transfer that property for the payment of $250,000 in cash. At the closing Danielle would first complete an exchange with Wilbur transferring the Montana ranch to him in exchange for his transfer of the Minnesota farm to her. She would then transfer the Minnesota farm to the buyer for Buyer's payment of $250,000 in cash. Danielle would use that $250,000 to pay off her debt to Wilbur.

Wilbur agreed to this deal since Danielle said it would be advantageous from a tax standpoint, and the various steps were carried out before the end of 1990. At all times during 1990 the Montana ranch had a fair market value of $200,000.

About one year later Wilbur became dissatisfied with life in Montana. He had not done his research well before moving and was surprised that half of his neighbors were rich Californians with more arriving every day. He decided to move to Alberta to really get away from it all. Before leaving he executed a deed in which he gave a life estate in the Montana ranch to his daughter, Anne, with remainder to her son, David. He still loved the setting of the ranch (it was the people he could not stand), and hoped to visit his daughter there from time to time.

Anne was anxious to develop the ranch, but knew that it would be several years before she would be ready to leave her job in Minneapolis to settle permanently on the land. She found a tenant named Bill Graze who agreed to lease the ranch property for 10 years. Graze agreed to pay cash rent of $12,000 per year and also agreed to build several ranch buildings on the property with the site of these to be determined by Anne to fit with a new ranchhouse she planned to build at the end of the lease term. The fair rental value of the land was $15,000 per year. This lease was signed in July of 1992, and Graze put up several buildings by the end of 1993. The cost of these buildings was $20,000 not including Graze's labor, and they were expected to last about 25 years.

In 1995 the influx of Californians became too much even for Graze, and he decided to try Alaska. He called Anne to tell her that he was sorry, but that he planned to abandon his lease obligation. He sent her a check for $5,000 explaining that it was all he could afford to pay, but that he felt an obligation to settle some part of what he owed her. He also sent a note in which he stated that he was abandoning all interest in the lease. At the time the buildings were worth $30,000.

In May of 1996 Anne decided to drive to Two Dot to check on the condition of the property and try to find another tenant. On the way out she was killed in a head on collision. David then became the owner of the property by virtue of his remainder interest. At that time the land had a value of $400,000 and the improvements were worth $31,000.

David did not want to have anything to do with the property which he associated with his mother's death. He did want to take advantage of its value and borrowed $300,000 on a nonrecourse basis using the property as security. Then, because he knew that his mother would have wanted the property be used for a good purpose, he donated it subject to the debt to the Children's Nature Group for development as a camp for disadvantaged young people. At the time of this donation the property was worth $400,000.

How should these transactions be reported by Wilbur, Anne, Graze and David?