MEMORANDUM TO: Senior Partner FROM: J.D. Team Number ______ DATE: November 5, 2010 SUBJECT: 2010 Law Student Tax Challenge Problem QUESTIONS PRESENTED I. Which property should Irons transfer to Janna, and which of her lawyer’s alimony proposals should Irons accept? II. To what extent may Irons deduct expenses associated with his trip to the training spa? III. What are the Federal income tax consequences of Irons’ winning $2 million? IV. Do the LMN bonds offer a deferral benefit and what are the Federal tax consequences? V. Whether Irons has other Federal tax liabilities or items of income? CONCLUSIONS I. Irons should transfer the $40 million in the form of DEF marketable securities and the West Palm house. Irons should accept the second proposal. II. Irons should currently deduct: $6,400 for travel, $5,000 for swing lessons and fitness training, $2,000 for golf shoes, and $8,000 for golf clubs. Irons should deduct the lodging expenses for the first nine days and 50% of his meal expenses for the first seven days of his stay at the training spa ($9,560). Irons should not deduct the $6,000 expense for his golf wardrobe. III. Irons will have to include the $2 million in prize money as ordinary income. IV. The LMN bonds do not offer a deferral benefit, but do result in tax consequences for Irons. V. See Part V discussion below.

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ANALYSIS I. PROPERTY TRANSFER AND ALIMONY I.R.C. § 1041 governs the treatment of property incident to divorce, and the choice of which property to transfer and the payment of cash or securities depends on the tax goals of the taxpayer. Property transfers incident to divorce receive gift treatment. I.R.C. § 1041. The transferor recognizes no gain or loss, and the transferee assumes the transferor’s basis in the property. I.R.C. § 1041(b)(2). If Irons transfers $40 million in securities from the DEF Fund, Irons will not recognize any gain or loss. Janna will have a basis equal to Irons’ basis before the transfer and will recognize the built-in gain upon sale. By transferring the money in the form of the DEF fund, Irons will be able to avoid the gain he would recognize if he instead sold the securities. Similarly, if Irons transfers the Palm house, Irons recognizes no gain, and Janna assumes the property with a basis of $4 million. Thus, Irons should transfer property with the highest built-in gain, as he will avoid recognizing that gain if he later sells the property. Irons could claim that if he pays the $40 million in cash he would qualify for § 71 treatment. However, according to the Tax Court, “Payments which are part of a property settlement are capital in nature and, therefore, are not subject to the provisions of § 71.” Yoakum v. Comm’r, 82 T.C. 128 (1984). Janna and Irons have designated this transfer as a property settlement, thus a cash transfer would be unlikely to qualify for § 71 treatment; and any such payment would be subject to the recapture rules discussed below. I.R.C. § 71(f). A. DIVORCE PROPOSALS Generally, alimony payments are deductible under § 215, which states that a taxpayer may deduct “an amount equal to the alimony or separate maintenance payments” as defined in § 71. I.R.C. § 215(b). Under § 71, the payee spouse must include the payments in his or her gross

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income. I.R.C. § 71(a). The Code requires that the payments must be in cash and pursuant to a divorce or separation instrument, that the couple does not opt out of the general rule, and that the payor spouse is not liable for payment after the death of the payee spouse. I.R.C. § 71 (b)(1). The Code provides further limitations on deductibility through front-loading of alimony and child support rules. I.R.C. § 71(c), (f). Proposal 1 (“P1”) requires Irons to pay annually $4 million from 2010 – 2020, $3 million from 2021 – 2025, and $2 million thereafter. While these payments initially seem deductible in full, § 71(c) excludes from alimony treatment payments associated with contingencies involving children. I.R.C. § 71(c). A contingency reduces alimony when the contingency is specified in the divorce instrument or when the reduction “can clearly be associated with a contingency.” I.R.C. § 71(c)(2)(B). The regulations state that “payments are to be reduced on two or more occasions which occur not more than one year before or after a different child of the payor spouse attains a certain age between the ages of 18 and 24, inclusive.” Temp. Treas. Reg. § 1.71-1T(b), Q&A 18. The regulations also require that the age be the same for each child. Id. Here, the payments decline twice upon such events: when the first child reaches 18 in 2021 and again when the second child turns 18 in 2025. Thus, the Service will consider $1 million of the alimony payments between now and 2020 as child support payments for the first child and $1 million of the payments between now and 2025 as child support for the second child. Only $2 million of the payments constitute alimony under §71, and Irons can deduct only that amount under § 215. Payments under §71 must cease upon the death of the payee spouse. I.R.C. §71(b)(1)(D). Irons must convince Janna to include a provision terminating payments upon her death, or none of the payments are deductible by Irons. See Temp. Treas. Reg. 1.71-1T(b), Q&A 11.

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Proposal 2 (“P2”) calls for payments in decreasing amounts over three years, plus additional payments of $2 million in child support per child, per year, until age eighteen. As noted above, Irons cannot deduct the child support payments. I.R.C. § 71(c). Furthermore, § 71(f) prevents taxpayers from disguising property settlements as alimony payments by requiring the payor and payee spouse to recalculate alimony payments under § 71 when the payments are front-loaded. I.R.C. § 71(f). The payor must include in gross income in year 3 (2012), the sum of the excess payments in year 1 and 2 (2010 and 2011). I.R.C. § 71(f)(2). The calculations of the excess payments in these years will result in a total excess payment of approximately $20 million in 2012. Thus, in 2012, Irons will have to include $20 million in his gross income. P1 appears to be the better option, provided the agreement specifies that the payments cease upon Janna’s death. Under P2, Irons would get a $25 million deduction this year, but he does not have enough income to offset that deduction and would have to liquidate assets to cover payments, triggering capital losses or gains. He also faces a $20 million inclusion in income in 2012, with no guarantee that he will have sufficient assets with which to pay the tax liability. Finally, under P1, Irons is only paying the equivalent of $1 million in child support per child, whereas he is paying $2 million per child under P2. Furthermore, the front-loading principal will not apply to P1, giving Irons a $2 million deduction per year for the remainder of Janna’s life. The couple can opt out of the § 71 treatment of payments as alimony. I.R.C. § 71(b)(1)(B). With an election, Janna would not include payments in gross income, Irons would not deduct them, and the front-loading provisions would not apply. Irons still would have to liquidate assets to make payments and deal with the corresponding capital loss or gain. An election may make sense if Irons has other desires beyond minimizing his personal tax liability, such as limiting Janna’s tax liability.

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As a final note, the default rule gives the dependent exemption to the custodial spouse. I.R.C. § 152. The Code allows couples to opt out of this default rule by agreement. I.R.C. § 152(e)(2). Here, Janna has agreed to allow Irons the deduction, but both parents must attach declarations stating such to their return. Id.; see also Treas. Reg. § 1.152-4(e)(1) (allowing declarations to release the exemption for multiple years). The spouse with the dependency exemption also gets the Child Care Credit, subject to phase-outs. I.R.C. § 24. II. THE DEDUCTIBILITY OF THE EXPENSES INCURRED DURING IRONS’ TRIP TO CALIFORNIA. In preparation for his return to competitive golf on the PGT, Irons spent two weeks at an elite training spa in California where he incurred a variety of expenses. Irons would like to determine which of these expenses may be properly deducted in tax year 2010. Irons may deduct “all the ordinary and necessary expenses paid…in carrying on any trade or business,” and the expenses incurred for the production of income. I.R.C. § 162(a); I.R.C. § 212. Conversely, I.R.C. § 262(a), excludes deductions for personal or living expenses, while § 274 generally disallows entertainment or recreation expenses. To be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and for the primary purpose of profit. See Comm'r v. Groetzinger, 480 U.S. 23, 35 (1987). For additional guidance, the Treasury regulations provide a nonexclusive list of nine factors to determine whether an activity is engaged in for profit. See Treas. Reg. § 1.1832(a). As Irons’ sole income for 2010 resulted from his golf winnings and he remains a member of the Professional Golf Tour (“PGT), he should be deemed to be engaged in a trade or business. Irons, as a professional golfer, appears to meet the threshold inquiry for a trade or business. See Groetzinger, 480 U.S. at 35; Treas. Reg. § 1.183-2(a).

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However, the Service could proffer an argument that due to his leave of absence, Irons was not “carrying on a trade or business” at the time these expenses were incurred. Although unlikely, if successful, Irons expenses would be deemed personal in nature and the deductions would be disallowed under §§ 262 or 274. B. ORDINARY AND NECESSARY EXPENSES. “Ordinary” means an expense that is normally to be expected in the circumstances of the business, Deputy v. DuPont, 308 U.S. 488 (1940), while “necessary” has been construed to mean appropriate and helpful to the business. Welch v. Helvering, 290 U.S. 111, 113-14 (1933). 1. Travel Expenses. Expenses for business related travel have three prerequisites in order to be deductible: the expenses must be incurred while away from home, be in the pursuit of a trade or business, and be necessary and reasonable in amount. See Comm’r v. Flowers, 326 U.S. 465, 470 (1946); Treas. Reg. § 1.162.2(a). Each of these three criteria is satisfied with respect to Irons’ travel expenses: Irons’ resides in Florida, his principal place of business is not California, and he visited the spa to prepare for his return to professional golf. He was pursuing the business of being a professional golfer by practicing, training, and meeting with potential new sponsors. The use of a limousine and private jet were reasonable given Irons’ notoriety as a professional golfer and prominent public figure. The expenses were not extraordinary and the Tax Court has previously upheld the deductibility of similar luxury expenses. See Denison v. Comm’r, 36 T.C.M. (CCH) 1759 (1977). 2. Week One v. Week Two Expenses. Irons stayed at the training spa for two weeks and arguably engaged in both business and personal activities. During the first week, Irons trained with both a swing coach and fitness trainer daily. Practice and fitness are appropriate and helpful to a professional golfer and the customary expenses that a professional golfer incurs.

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Additionally, the lessons with the swing coach are deductible as expenses for education because the lessons maintain and improve skills required by Irons in his trade. See Treas. Reg. § 1.1625(a)(1). Section 162 permits a deduction for Irons’ meals and lodging while staying at the spa. Irons may deduct the $1,000 per night cost because he can substantiate that this expense falls within the specifications of the regulations as “directly related to the active conduct of the taxpayer’s trade or business” and reasonable under the circumstances. Treas. Reg. § 1.2742(a)(i); Rev. Rul. 63-144, 1963-2 C.B. 129. The meals took place during practice and training and are consequently associated with the conduct of his trade or business. I.R.C. § 274(a)(1). However, all deductions for meals are limited to 50% of the amount spent. I.R.C. § 274(n). Should the service attempt to argue that the meals or lodging expenses are “lavish or extravagant under the circumstances,” under § 162(a)(2), the determination is made under the facts and circumstances. If the Service were successful, the amount that is deemed reasonable will still be deductible. I.R.S. Notice 87-23, 1987-1 C.B. 467. Some of Irons’ expenses during the second week are more difficult to determine proper deductibility as they appear to be more representative of personal expenses. Treas. Reg. § 1.3631(b). However, the first two days of the second week appear to have a strong business purpose as he spent the day meeting with potential new sponsors. Presumably, Irons engaged in “substantial business discussions,” Treas. Reg. § 1.274-2(d)(3)(i)(a), that were related to his professional golf career. It should not matter that the discussions were held at the training spa. However, Irons will be unable to deduct the meals during the first two days of the second week as those meals were paid by the sponsors, and thus properly deductible by the sponsors. Irons spent the remainder of the second week “largely relaxing,” but he could argue that this too was conditioning and appropriate and helpful to his golf game. However, the Court of Appeals for the Second Circuit

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has noted that “[n]ot everything that is done to develop one’s body, even if one is a professional athlete, is necessarily for business.” Stemkowski v. Comm’r, 690 F.2d 40, 46 (1982). Other athletic off-season expenses have been disallowed by the Tax Court, usually for a lack of substantiation. See, e.g., Horton v. Comm’r, 86 T.C. No. 589 (1986). The determination is a fact-specific inquiry and Irons runs the risk of disallowance because he “largely relaxed” during the second week. Irons should not deduct the expenses incurred for meals and lodging during the final five days at the spa, as these appear, on balance, not to be ordinary and necessary to his trade as a professional golfer. 3. Wardrobe and Club Expenses. The general rule of law is that where business clothes are suitable for general wear, a deduction for them is not allowable. See Donnelly v. Comm’r, 262 F.2d 411 (2d Cir. 1959). See also, Rev. Rul. 70-475, 1970-2 C.B. 35 (jockey’s riding apparel deductible as a business expense); Rev. Rul. 70-476, 1970-2 C.B. 35 (professional baseball player’s uniforms deductible as business expenses). But cf. Mella v. Comm’r, 52 T.C.M. (CCH) 1216 (1986) (professional tennis player disallowed deductions for tennis clothes and shoes). Irons golf clothes (assuming a golf polo shirt and slacks) are most likely suitable for general wear, so no deduction is available. However, Irons’ golf shoes (assuming bearing spikes) are not suitable for everyday wear and he should deduct this $2,000 expense. Irons would prefer to currently deduct the $8,000 spent for two sets of golf clubs, however, Irons may be required to capitalize the expense for his new golf clubs. I.R.C. § 263. If capitalized, Irons would take depreciation deductions over the useful life of the golf clubs. I.R.C. § 167. However, Irons should argue that the golf clubs are incidental materials and supplies and therefore currently deductible. Treas. Reg. § 1.162-3. Also, if his golf clubs do not have a useful life beyond one year then they should be currently deductible. I.R.C. § 263.

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III. PRIZE MONEY The I.R.C. defines gross income as “all income from whatever source derived.” I.R.C. § 61(a). Section 61 provides examples of sources of income, but specifically does not limit sources of income to those examples. Id. Section 74 expressly states that “gross income includes amounts received as prizes and awards.” I.R.C. § 74. Case law further defines income as “undeniable accessions to wealth, clearly realized, and over which the taxpayer[] [has] complete dominion.” Comm’r v. Glenshaw Glass, Co., 348 U.S. 426, 431 (1955). Here, Irons meets all three of the requirements of the Glenshaw Glass definition of income, and the prize money would be taxable even if § 74 did not apply. The exceptions in § 74 do not apply here. I.R.C. § 74(b)-(c). IV. THE LMN BONDS INVESTMENT. Irons’ financial adviser’s advice is incorrect, as the original issue discount (“OID”) rules deny a deferral benefit, and result in the inclusion of the yearly OID amounts in Irons’ gross income for 2010 and 2011, and for each year thereafter until maturity. The LMN bonds are zerocoupon debt instruments and the OID rules require the inclusion in gross income of the OID amounts to equalize the timing of income and expenses. I.R.C. §§ 1272-1273. The amount to be included in the bondholder’s gross income is equal to the sum of the daily portions of the OID for each day during the taxable year in which the debt instrument was held. I.R.C. § 1272(a)(1). Irons’ $1 million investment will reap $1.5 million at maturity. The total OID on Irons’ LMN bonds will be $500,000. I.R.C. § 1273(a). For 2010, Irons must include in gross income, the portion of OID for the period from October 1, 2010 to January 1, 2011. Irons will have to include $5,000 in OID interest for this portion of 2010. Treas. Reg. § 1.1272-1(b)(4)(iii); I.R.C. § 1272(a)(3)(calculated using the constant-yield to maturity method, with a six-month accrual period and yield-to-maturity of 2.05% for each period). In 2011, Irons’ OID interest inclusion

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will be $41,844.81 ($20,710.13 for first 6 months plus $21,134.68 for the second 6 months). Irons’ basis in the LMN bonds will be gradually increased by the amount of OID included in his gross income and, consequently he will realize no gain at maturity. Treas. Reg. § 1.1272-1(g). V. OTHER ISSUES The $4 million in blackmail money is not deductible as a business expense. See Wells v. Comm’r, 47 T.C.M. (CCH) 1114, 1117 (1984). As Irons is not itemizing deductions, characterizing the rehabilitation stay as medical expenses is irrelevant. I.R.C. § 63(e); I.R.C. § 213. He can argue that the stay constitutes a legitimate business expense in that it is necessary to maintain his image. See Jenkins v. Comm’r., 47 T.C.M. 238 (CCH) (1983), non acq. in action on decision 1984-022 (Nov. 3, 1983). The business expenses incurred in 2010 must be applied against the business income first. Irons cannot first deduct alimony from the prize money, then the business expenses. I.R.C. § 172(d). Consequently, he cannot claim a net operating loss that could be carried forward. The meals paid by the sponsors do not constitute imputed income. The Supreme Court has suggested that unless the code specifically says otherwise, imputed income is not included in gross income. Helvering v. Independent Life Ins. Co., 292 U.S. 371 (1934). Section 162 expressly disallows a deduction for any fine paid to a government for a violation of any law. I.R.C. § 162(f). However, Irons was fined by the PGT for a violation of their personal conduct policy, so the Code does not specifically disallow a deduction in this case. The fine could be more properly characterized as an ordinary and necessary business expense. Irons would be unable to return to golf without paying this expense, and the payment of fines has become common or ordinary in professional sports. The Tax Court has allowed deductions under a similar analysis. See Rothner v. Comm’r, 72 T.C.M (CCH) 801 (1996).

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LAW OFFICES OF J.D. TEAM NUMBER ______ Tax Town, ABA State, 10000 Client Tax Town, ABA State, 10000 Re: 2010 Law Student Tax Challenge Problem Dear Mr. Irons: Congratulations on your recent victory at the Bushwood Country Club Championship. You have requested our advice concerning the Federal income tax consequences of several recent events and expenses. We have attempted to account for your personal and tax objectives in formulating our recommendations. Below, we first provide our conclusions and then provide a summary of our reasoning. We recommend that you transfer the West Palm house and $40 million in the form of DEF Fund securities. We further recommend that you accept the first divorce proposal, but only if you include a clause terminating alimony payments upon her death. With respect to the expenses incurred during your visit to the training spa in California, in 2010 you should deduct: $6,400 for travel, $5,000 for swing lessons and fitness training, $2,000 for golf shoes, and $8,000 for golf clubs. However, we suggest that you only deduct the lodging expenses for the first nine days at the spa ($9,000), and 50% of the meal expenses for the first seven days ($560) because the remaining part of your stay is likely to be characterized as personal. Because your golf wardrobe is suitable for general wear, you are not permitted to deduct this $6,000 expense. You must include the $2 million in prize money in your gross income for 2010. The LMN bonds do not offer a deferral benefit, but instead this investment will result in tax consequences for 2010 and every year thereafter until the maturity date of the bonds. As discussed below, we believe these recommendations best accomplish your personal tax goals within the parameters of the Federal tax laws. 11

PROPERTY TRANSFER AND ALIMONY We recommend that you transfer the DEF fund and the West Palm house. This way, you avoid paying tax on the gain upon any sale. If you chose to liquidate any of the securities, you face a gain or loss. By transferring the DEF fund, Janna must pay the tax on the gain when she sells the fund. Similarly for the house, by transferring the most appreciated property, you avoid having gain associated with any potential sale of the house. We also recommend proposal one. Under this proposal, you may deduct $2 million per year from your gross income for the length of the agreement. Further, under this proposal, you are only paying $1 million in child support per child per year, whereas under the second proposal you are paying $2 million per child. You must include a provision ceasing payments upon Janna’s death or you will not be entitled to deduct any of the payments. Proposal two triggers tax rules that will require you to include about $20 million in your 2012 income. This inclusion is a result of the tax code’s attempt to prevent taxpayers from disguising property transfers, generally not deductible, as alimony, which are deductible. If you are truly set against proposal one, then you may want to consider proposal two, but you should opt out of the deduction in writing. This will eliminate the $20 million inclusion of income in future years. THE EXPENSES INCURRED DURING THE STAY AT THE TRAINING SPA IN CALIFORNIA As summarized above, some of the expenses incurred during your stay at the training spa in California are most likely deductible and others will likely be deemed nondeductible personal expenses. The deductibility of these expenses turns on whether they are directly related to your trade or business because the Federal tax rules allow a deduction for ordinary and necessary expenses incurred in the carrying on of a trade or business. Based on the information you provided, most of your expenses incurred at the training spa should be properly deductible in

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2010 because they are directly connected to your business as a professional golfer. You elected to attend the training spa in preparation for the Bushwood Championship, and while there incurred expenses to improve your athletic fitness, technical skills, and produce further income through sponsorships. These activities suggest the appropriate nexus to your trade or business as a professional golfer and therefore you should deduct the expense of travel, swing lessons, fitness training, and your lodging during the first nine days. The tax rules limit the deduction for your meals to 50% of the expense and you are not entitled to deduct the meals paid for by potential sponsors. Additionally, because golf shoes and golf clubs are expenses ordinary and necessary to playing golf, these expenses should be deducted. Because your final five days were primarily spent on personal activities and relaxing, you should not deduct your meals and lodging for those days. The tax rules provide a deduction for work clothing only when that clothing is not suitable for general or everyday wear. Because your golf wardrobe is capable of general wear, these expenses may not be deducted. PRIZE MONEY The $2 million prize constitutes ordinary income and must be included in gross income. LMN BONDS INVESTMENT Although the investment in LMN bonds may satisfy your desire for a conservative investment, you will be unable to defer tax on the interest payments. The LMN bonds do not pay any stated interest, but at maturity the LMN bonds will pay you a premium that is greater than your initial $1 million dollar investment. The unstated interest is known as the original issue discount or OID. The tax rules account for this discounted arrangement by requiring the taxpayer to include a portion of the OID during each year that the investment is held. Under the OID rules,

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in 2010, you will have to include $5,000 as income from the bonds, and in 2011, you will include $41,844.81 as income. OTHER FEDERAL TAX LIABILITIES OR ITEMS OF INCOME While reading your client file, we contemplated several other issues that you may want to consider with respect to federal income tax consequences, deductions, and items of income. The Tax Court has previously stated that the $4 million in blackmail money is not deductible as a business expense. The tax rules provide a deduction for medical expenses, and if you elected to itemize your deductions you could characterize the rehabilitation stay as a deductible medical expense. Additionally, you could argue that the rehabilitation stay constitutes a legitimate business expense in that it is necessary to maintain your image. You will be unable to claim a net operating loss for the year and will be unable to use all of your allowable deductions for 2010 because your deductions exceed your gross income. The meals paid by the sponsors raise a concern of imputed income, however, there is no provision in the code to require you to include these meals as income. You received a $100,000 fine by the PGT and you should deduct this as a business expense. You would have been unable to return to golf without paying this expense, which makes this expense necessary, and the payment of fines has become common or ordinary in professional sports. I trust that you find this letter helpful, please call us so that we can answer any questions and discuss your next course of action and additional assistance.

Sincerely, J.D. TEAM NUMBER______ 14