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). 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.
 
 

Rich, a 37-year-old divorced man, is a trial attorney in a large corporate law firm. He has been an employee at the firm for 10 years. He has always wanted to become a partner in the firm, but the existing partners have made it clear that he will never be made a partner, though he will always be welcome as an employee. Rich has been very successful as a lawyer and earns a salary and bonus from the firm every year in excess of $100,000. Over the years, he has saved many thousands of dollars, which he has invested in the stock market.

Rich has played the guitar since childhood. He and his friends had several amateur rock bands during his high school and college years. Once he entered law school, however, Rich stopped playing regularly.

In 2001, Rich begins playing his old guitar more frequently, and he finds that it greatly relaxes him from the stress of his job. By the end of the year, he is playing the guitar by himself at home every evening after work, and several hours each weekend. In November 2001, he is hired by a neighbor to play and sing at the neighbor's wedding, for which Rich is paid $250. It is the first paying job Rich has ever had as a musician.

During 2002, Rich begins taking voice lessons from a private tutor in the tutor's home. By mid-summer, Rich is hired to play shows at bars and restaurants. Rich receives $50 to $100 for each evening's performance, in which Rich sings and plays alone. Rich drives his car to and from the shows he puts on. In May 2002, he purchases two new guitars for $3,500 each, and 14 sets of new guitar strings at $15 each. Given how much Rich is playing, the strings last only a few weeks.

In September 2002, he informs his law firm that he will no longer be available for weekend legal work because he is so busy with his music activities. Rich tells his friends, "I have a new dream -- some day, I'll quit the law and become a rock star." One of his friends with extensive experience in the music industry tells him, "You can't make any money in this business. You don't know anything about it. You'd better keep your day job." Undaunted, Rich has business cards printed up in October 2002, at a cost of $60, that identify him as a "guitarist/vocalist extraordinaire."

Rich keeps good records of his personal checking account, which is his only bank account. Using those records, and a driving log that he keeps in his automobile, he determines that his receipts and disbursements attributable to his music for 2002 are as follows:
 

Received	Amount	Spent	Amount
Pay from shows	$ 1,300	New guitars	$ 7,000
		Voice lessons	610
		Business cards	60
		Strings	210
		Mileage: 329 miles @ 36.5 cents a mile	120
Total	$ 1,300	Total	$ 8,000

Assuming that for tax purposes guitars have a "class life" (as described in Section 168(i)(1) of the Code) of 12 years, what are the federal income tax consequences to Rich in 2002 of each of the transactions just described, with and without all available elections? Be sure to discuss the amount, timing, and character (ordinary or capital) of each item of income, gain, deduction, loss, or credit, and Rich's basis in his assets, at each stage of the transactions discussed.

Discuss.

Sally owns Blackacre, a parcel of undeveloped real estate that she has been holding for investment for several years. Her adjusted basis in Blackacre is $100,000. The property has a fair market value of $200,000, but it is encumbered by a mortgage that secures a loan of $25,000, so that Sally's "equity" in the property is $175,000.

Sally is approached by a buyer, Bertha, a real estate dealer, who wishes to buy Blackacre for $175,000 cash plus assumption of the mortgage. However, at Sally's suggestion, the parties enter into a "three-way" exchange agreement among Bertha, Sally, and a third party named Oliver. Pursuant to the agreement, on April 1, 2002, Sally transfers Blackacre to Bertha, and Bertha assumes the mortgage on Blackacre. Two weeks later, also pursuant to the agreement, Bertha purchases a two-story apartment building, Whiteacre, from Oliver for $175,000, which is Whiteacre's fair market value. Immediately thereafter, Bertha conveys Whiteacre to Sally. Sally takes over the business of renting Whiteacre to the existing tenants of the building.

Sally spends much of her spare time windsurfing. On a particularly blustery day out on the river, she collides with another amateur windsurfer, Gretchen. Sally sues Gretchen and is awarded $25,000 compensatory damages for physical personal injury, and for damage to her windsurfing gear, which is destroyed in the mishap. Sally promptly uses all of the damages to replace and upgrade her wrecked gear, which had been wearing out anyway. Sally pays a sizeable fee to her attorney for bringing the lawsuit on her behalf.

What are the federal income tax consequences to Sally of each of the transactions just described, with and without all available elections? Be sure to discuss the amount, timing, and character (ordinary or capital) of each item of income, gain, deduction, loss, or credit, and Sally's basis in her assets, at each stage of the transactions discussed.

Explain.

Created by: <bojack@lclark.edu>
Update:   02 Jun 02
Expires:  31 Aug 02