I. (20% of final grade)

Many features of the current income tax system have been criticized as making it too complex without adding to its fairness.Some features are criticized as unduly influencing citizens’ economic decisions solely for tax reasons.Consider three features of the system:

(1) the progressive rate structure;

(2) the favorable treatment for long term capital gains; and

(3) the failure to tax unrealized appreciation and the necessity of determining basis for property acquired some years before realization.

Evaluate these features of the system and discuss whether they support or go against the criticisms.

II. (30% of final grade)

Mark Swift was the head of design for Sunset Sailboats; his specialty was development of designs for high speed racing boats.Although these boats accounted for a relatively small portion of total sales of the company, they were very useful in advertising, and favorable publicity about them translated directly into increased sales for more conventional boats.Mark developed designs himself and supervised a staff of 8 designers.He also spent 2 weeks a month traveling around the United States to meet with sailors of all abilities to get ideas for new products and to get reactions to recently released models.He found that sailors could tell him exactly what features would make a boat sell.On these trips he used Sunset’s Gulfstream jet, stayed only in the most expensive hotels and ate at the best restaurants.Although Sunset’s management sometimes questioned his extremely high expenses, they were well aware that the exceptional success of his department kept the whole company afloat.Sailing was a luxury activity that catered to wealth, and Mark’s style of travel was necessary, he said, to reach the company’s clientele.

The company did balk when it came to paying his restaurant bills when he dined alone while traveling.Even when alone he would spend over $100 for a meal.The company would reimburse him only $30 on such occasions.Sunset also drew the line when it came to paying for the wine that Mark ordered not only when he was dining alone but when he was entertaining.He insisted that only the best wine would do for his guests or for him.He always ordered the best (and usually most expensive) wine on the list, often paying $200 or more for a bottle.The company reimbursed him only $25 for each bottle.

While sitting in his hotel room on one of his trips, Mark had a revolutionary idea of how to design the boat hull to achieve speeds not possible using present designs.He was not sure that present materials were up to the stress the new design would put on them, but he was sure he could make the thing work with a little time.Over the next weeks, he discussed his idea with two of the design staff he considered friends, not telling them what the design was, but asking their advice as to whether he ought to start his own company to develop the idea.He was pretty sure that he would not have trouble raising capital given his reputation and the ingenuity of his idea.

Somehow, management got wind of his discussions and asked him to develop the idea for the company.When he refused, Sunset discharged him under a company rule that prohibited appropriation of company intellectual property for personal gain.It promptly filed suit for an injunction against his commercial use of the idea without paying Sunset royalties.The court refused to enjoin Mark and dismissed the suit.

Mark soon convinced his old friend, Glen Glide, to help him with his project.Glide was an expert boat builder who immediately saw the promise of Mark’s idea and set out to find the right structural components to make it work.Together they secured a bank loan of $250,000 to finance the project and built a prototype whose performance surpassed even Mark’s optimistic forecast.They took the new boat to a race near San Diego and it won its class by huge margins.It was so good that every sailboat company in the country bid for the right to exploit Mark’s and Glen’s new patent.

After much deliberation, Mark and Glen sold their rights in the patent to Mainline Sailing, Inc., in October of 1996.At that time Mainline gave them each $500,000 cash, Mainline stock worth $4,000,000 and agreed to pay the loan, which still had a balance of $250,000.Mark and Glen also were each given consulting contracts which would pay each of them $300,000 per year for the next 10 years.Mainline placed $1,500,000 in an irrevocable trust account payable to itself to finance the payment of its obligation under this part of the agreement, and Mainline’s principal shareholder, George Yankee, signed a personal guarantee for the installment payments.

When the acquisition of the patent by Mainline was announced, its stock price doubled within a week.By the time the first boats became available for sale in December of 1997, the shares owned by Mark were worth $12,000,000.On December 30, 1997, Mark gave ¼ of his stock in Mainline worth $3,000,000 to his college, Illinois Institute of Technology.

In the meantime, Sunset sued Mark for $10,000,000 for wrongful appropriation of its intellectual property.He counter sued for breach of his employment contract.In 1998 a jury found against Sunset on all counts and awarded Mark $50,000 which Sunset paid last December.Mark paid his attorney’s fee for the action of $60,000; he was delighted with the outcome.

After the suit was over, Mark decided that he was going to travel for a year or two and that he had no need for his house.When he put it up for sale, he could not believe his luck.He was talking to a prospective buyer, Janice Wells, when she told him of the world class wine collection she had recently inherited from her husband, and the tragedy that her health did not permit her to drink wine.Eventually they worked out a deal whereby she paid him $100,000 in cash and gave him the wine collection which was worth $200,000, and he would transfer the house, which he had bought for $120,000, to her.She also agreed to let him keep the wine he already owned and the newly acquired wine in the wine cellar in the house until he returned.The cellar was the best money could buy and guaranteed that all of the wine would be safe until he returned.

What are the federal tax consequences of these transactions to Mark, Sunset and Janice Wells?

III (20 % of final grade)

Norma Ray inherited 1,000 acres of farmland from her mother in 1985 when it was worth $750,000; at the time it was also subject to a debt of $100,000.At first Norma did fairly well and was able to pay off the debt.When times got worse she borrowed several times eventually having a mortgage of $500,000 against the property.By that time farm values in the area had declined by almost half.The property was likely worth only about $400,000, and she was long in default on the mortgage.She decided to leave the business and found a buyer, Tina Simms, who purchased the land by taking it subject to the debt and paying Norma $7,500.Tina did not assume the mortgage.

Not long ago Tina learned from a realtor friend that Dizzy Company was going to develop a theme park about a mile from her property.If Dizzy did so, it is likely that the road past her property would be substantially improved because it provided the most direct access to the park site from the largest interstate interchange in the area.She also guessed that her property would become more valuable for development.

She went to Distant Bank, which had acquired the mortgage on her property in the secondary market and offered to buy the mortgage for $375,000.The bank agreed deciding that its costs of foreclosure of such distressed property made it a good deal.It was not aware of the Dizzy plans and sold the mortgage securing the $500,000 debt to Tina for $375,000.

A short time later Dizzy did indeed announce the new park for the site near Tina’s property.When the Distant Bank learned of this, it sued Tina alleging fraud in her failure to disclose her knowledge of the impending development.Although she thought the suit had no merit, Tina eventually settled by paying the bank $25,000.She still considered herself well ahead in the deal.

1) How should Norma Ray report her transaction?

2) What are the income tax consequences to Tina of her purchase of the mortgage from Distant Bank?

3) What are the income tax consequences of the eventual settlement with Distant Bank?

IV (30 % of final grade)

Assume that you have recently begun to practice law and that you have received inquiries from several clients seeking your advice as to tax matters.In each of the following situations, briefly advise the client, explaining your advice and setting out the reasons for your advice.

1) Mike Burke owns a painting on velvet of Elvis Presley done by an unknown artist.Though often copied, Burke’s painting is the first of its type and surprisingly valuable.He paid $12,000 for it in 1993 when Elvis memorabilia was very popular.He recently had it appraised and discovered that it would likely bring only about $7,500 if he sold it now.That is the amount that he is going to give his daughter to finance her last semester of college, and he asks you whether he should sell it himself and give the proceeds to his daughter or give the painting to his daughter and let her sell it.He has told you that he and his daughter are in the same marginal tax bracket.Advise him.

2) Mary Stevens owns a small company that designs Web sites.Her employees work long hours and are quite sedentary during work.She wants to encourage them to exercise because she believes fit employees are more productive.She is considering three options to provide an encouragement for exercise.She will either 1) build a small workout facility in her company building and a running track around the grounds, 2) pay for a membership for each employee at the Deluxe Training Spa, a private club down the street from the company or 3) pay the dues of each employee at a workout facility of the employee’s choice.She wants to know if she should adopt a plan giving the employees the option to choose from among these benefits or whether she should choose one and provide only it.If she chooses only one option, which one will provide the greatest tax benefit to both the company and the employees?

3) Juan Rodriguez recently resigned from his position as an executive for Widgets, Inc.He received a severance settlement in which the company agreed to pay him $25,000 per year for each of the next 5 years.He wants to help his son with a new business the son is starting and has asked whether he can assign one half of the right to receive these payments to his son and thereby shift the income tax on the assigned amount to his son.Advise him.

4) Vada Miller is a country music singer who was a shareholder in a production company that went bankrupt after promoting several tours last year.She played on the one successful tour for the year, but it did not do well enough to prevent the failure of the company.She is now planning a tour of her own this summer and wants to hire some of the musicians who played with her on last year’s tour.Some of them are reluctant to join her band because they were not paid for last year due to the production company’s failure.Vada proposes to show her good faith to the musicians by paying them for last year from her own funds even though she has no legal obligation to do so.Before making any payments, however, she has asked you whether she will be able to deduct the amounts paid to the musicians under these circumstances.The amount she can afford to pay is dependent on whether she can deduct the payments.What do you advise her?

5) Laura Evans lives in Minnesota but has been advised by her doctor that she should spend December, January and February in southern Florida as treatment for her Seasonal Affective Disorder (SAD).(This is a recognized disorder in some persons that results in severe depression during periods of the year when there is little sunlight.)She spends $500 during the year on airfare to make the prescribed trip and incurs $6,000 in meals and lodging expense while in Florida.She asks whether these expenses are deductible as medical expenses.Advise her.