Question

Without regard to the transactions or events described below, Cher Holder, who is a single taxpayer, has gross ordinary income of $60,000, §62 and §63 deductions of $20,000, and taxable income of $40,000 in the current year. Consider together the following further facts and then answer questions (a) through (d) which follow:

(1) Cher owns a $5,000 “note” of Flibinite Corporation which she got from the Corporation for a loan of that amount and which is supposed to pay five percent interest each year. Flibinite goes bankrupt and Cher’s “note” is worthless. The Commissioner successfully asserts that Cher’s “note” represents an equity contribution to Flibinite. Cher acquired the “note” two years ago.

(2) Cher owns common stock in Flibinite which also becomes worthless in the current year. She paid $3,000 for the stock three years ago

(3) Two years ago Cher loaned her friend Mooney $2,600. That loan becomes worthless in the current year. (What factors would be considered in determining if the loan created a bona fide debt?) Assume the debt was bona fide.

(4) Cher owned some tax exempt state bonds which she purchased for $8,000 four years ago. When they were worth $12,000 they were stolen and Cher received $12,000 in insurance proceeds in the current year.

A) To what extent will the above transactions reduce Cher’s taxable income for the year

B) What, if any, is Cher’s capital loss carryover to the succeeding year?

C) If, in addition, Cher had sold some stock for $20,000 which she had purchased three years earlier for $9,400, what is her taxable income for the current year? (Assume her other §62 and §63 deductions are still $20,000)

D) Assuming the facts of all parts including part (c) in the above problem, must Cher report any income (and if so what character of income) if in the following year Mooney inherits some money and repays her $2,600 obligation to Cher?

Answer 1

A. Cher's taxable income for the year will be reduced by following amounts:

Capital Loss (Note of Flibnite Corporation) $-5,000

Capital Loss (Common Stock in Flibnite Corporation) $-3,000

Total Capital Loss $-8,000

Capital Loss to the extent of only $3,000 can be adjusted against taxable income in a year. Balance has to be carried forward to set off next year.

Hence, new Taxable Income will be $37,000

Loan given to friend will be hard to prove to be bona-fide debt. A bona-fide debt is allowed as a deduction in the year in which it becomes worthless. However, it will be difficult for Cher to establish the Mooney has an obligation to repay and expresses his intention to repay. Also it will be hard for Cher to prove a debtor-creditor relationship on such loan.

Insurance proceeds received for lost tax exempt bonds are not required to be reported.

B. Net losses of more than $3,000 can be carried over to the following year for set-off. Hence, $5,000 will be carried forward for subsequent years.

C. Capital Gains (20000-9400) $10,600

Capital Losses (As calculated in A above) $-8,000

Net Capital Gains added to Taxable income $2,600

Taxable Income $42,600

D. No requirement of reporting the recovered debt from Mooney. Since, loss of such debt was not qualified to be reported, as explained in A above.