This second part of the examination consists of two essay questions, each of which will be given equal weight in determining grades. Two hours will be permitted for this part. At the end of the two hours, you must turn in both this set of essay questions and your answers in the original envelope in which this set came.

All answers must be entered in the bluebooks you have been provided (or, for those typing or operating computers, on separate sheets of plain white paper or a computer floppy disk). No credit will be given for anything written on this set of questions.

Pay close attention to the final portion, or "call," of each question. Failure to respond to the matters called for will result in a low score for the question. On the other hand, discussion of matters outside the scope of the call of the question will not receive credit.

Be sure to explain as thoroughly as possible your answers to the questions posed. Your reasoning, discussion, and analysis are often as important as any particular conclusion you reach.

The suggested time limit for each question is one hour. Experience has shown that failure to budget one's time according to this limit can result in a drastic lowering of one's overall grade on this examination.

Unless otherwise expressly instructed, assume that all taxpayers described in the questions are individuals, and that they report their income on the cash method and the calendar year for federal income tax purposes. Any references to the "Code" mean the Internal Revenue Code of 1986, as amended.
 
 

Eddie is a manager at a hamburger restaurant called Puckland. The restaurant has a forest "theme," and the employees, including Eddie, are all required to wear elf costumes while on duty. The company that owns and operates Puckland, a corporation known as Puxco, supplies, cleans, and maintains the costumes, which the company sends out weekly to be dry-cleaned. As manager, Eddie is allowed to include his own personal clothing with the company's dry cleaning on occasion, and the company pays for the cleaning. Eddie takes advantage of this about four times a year. On Halloween of 2002, he wears his elf costume to a party at a singles bar.

In 2002, as part of a company-wide plan, Puxco grants Eddie the option to purchase some shares of its stock, which is traded on a national stock exchange. The option, which is immediately vested, gives Eddie the right to purchase 10,000 shares of the stock for $2 a share, beginning on January 1, 2003. At the time the option is granted, Puxco stock is trading for $1.75 a share.

On July 15, 2003, when Puxco stock is trading for $3.50 per share, Eddie exercises his option and purchases 10,000 shares for $2 a share. He borrows $20,000 from a bank to make the purchase, granting the bank a security interest in (mortgage on) the stock. In 2003, Eddie pays interest of $650 on the bank loan. The Puxco stock is the only investment asset Eddie owns, and it does not pay dividends of any kind.

Early in 2004, Eddie sells all 10,000 of his Puxco shares for $5 a share, which he receives in cash. He uses part of the proceeds of the sale to pay off the bank loan in full. Eddie pays a commission of $500 to a broker to make the sale.

Later that year, at a company party to celebrate Eddie's birthday, his fellow employees present Eddie with a new bowling ball and matching bowling shirt. The purchase price of the ball and shirt, $225, is paid one-third ($75) by Eddie's fellow employees and two-thirds ($150) by Puxco.

What are the federal income tax consequences to Eddie of each of the transactions just described? Be sure to discuss the amount, timing, and character (ordinary or capital) of each item of income, gain, deduction, loss, or credit, and Eddie's basis in his assets, at each stage of the transactions discussed.

Discuss.

Michelle is a famous jazz singer. She is self-employed and works as an independent contractor, rather than as anyone's employee.

Michelle is 49 years old in 2002, and concerned that if she loses her youthful looks, she may lose popularity among her fans. Although her husband, Larry, tells her that she looks fine, she insists on exploring cosmetic surgery. She learns from her health insurance carrier that such surgery is not covered under her policy, because it is "not medically necessary."

Michelle approaches a plastic surgeon, Doc, who agrees to perform the operation for a fee of $30,000. After the surgery, which is successful, Michelle arranges to "pay" Doc by performing two shows at a nightclub of which Doc is part-owner. Michelle's normal fee for two club performances would be $30,000, and so her work satisfies her debt to Doc in full.

Shortly after the surgery, in 2002, Michelle purchases an annuity policy for $170,000. Under the policy, she will receive $10,000 a year for the rest of her life, beginning immediately. Michelle receives a $10,000 payment in 2002, and another $10,000 payment in 2003.

Early in 2004, Michelle performs in a large outdoor concert for which her fee is $200,000. After the concert but before Michelle is paid for her performance, Michelle is killed in the crash of a small aircraft. A few weeks later, the concert promoter pays the $200,000 fee to Larry, who is Michelle's sole heir. Larry keeps the money, which he is legally entitled to do.

What are the federal income tax consequences to Michelle and Larry of each of the transactions just described? Be sure to discuss the amount, timing, and character (ordinary or capital) of each item of income, gain, deduction, loss, or credit, and Michelle's and Larry's basis in their assets, at each stage of the transactions discussed.

Explain.