Chapter 14, Problem 58CP

John Benson, age 40, is single. His Social Security number is 111-11-1111, and he resides at 150 Highway 51, Tangipahoa, LA 70465.

John has a 5-year-old child, Kendra, who lives with her mother, Katy. As a result of his divorce in 2016, John pays alimony of $6,000 per year to Katy and child support of $12,000. The $12,000 of child support covers 65% of Katy’s costs of rearing Kendra. Kendra’s Social Security number is 123-45-6789, and Katy’s is 123-45-6788.

John’s mother, Sally, lived with him until her death in early September 2019. He incurred and paid medical expenses for her of $15,588 and other support payments of $11,000. Sally’s only sources of income were $5,500 of interest income on certificates of deposit and $5,600 of Social Security benefits, which she spent on her medical expenses and on maintenance of John’s household. Sally’s Social Security number was 123-45-6787.

John is employed by the Highway Department of the State of Louisiana in an executive position. His salary is $95,000. The appropriate amounts of Social Security tax and Medicare tax were withheld. In addition, $9,500 was withheld for Federal income taxes and $4,000 was withheld for state income taxes.

In addition to his salary, John’s employer provides him with the following fringe benefits.

• Group term life insurance with a maturity value of $95,000; the cost of the premiums for the employer was $295.
• Group health insurance plan; John’s employer paid premiums of $5,800 for his coverage. The plan paid $2,600 for John’s medical expenses during the year.

Upon the death of his aunt Josie in December 2018, John, her only recognized heir, inherited the following assets.

Three months prior to her death, Josie gave John a mountain cabin. Her adjusted basis for the mountain cabin was $120,000, and the fair market value was $195,000. No gift taxes were paid.

During the year, John reported the following transactions.

• On February 1, 2019, he sold for $45,000 Microsoft stock that he inherited from his father four years ago. His father’s adjusted basis was $49,000, and the fair market value at the date of the father’s death was $41,000.
• The car John inherited from Josie was destroyed in a wreck on October 1, 2019. He had loaned the car to Katy to use for a two-week period while the engine in her car was being replaced. Fortunately, neither Katy nor Kendra was injured. John received insurance proceeds of $16,000, the fair market value of the car on October 1, 2019.
• On December 28, 2019, John sold the 300 acres of land to his brother, James, for its fair market value of $160,000. James planned on using the land for his dairy farm.

Other sources of income for John are:

Potential itemized deductions for John, in addition to items already mentioned, are:

Part 1—Tax Computation

Compute John’s net tax payable or refund due for 2019.

Part 2—Tax Planning

Assume that rather than selling the land to James, John is considering leasing it to him for $12,000 annually with the lease beginning on October 1, 2019. James would prepay the lease payments through December 31, 2019. Thereafter, he would make monthly lease payments at the beginning of each month. What effect would this have on John’s 2019 tax liability? What potential problem might John encounter? Write a letter to John in which you advise him of the tax consequences of leasing versus selling. Also prepare a memo addressing these issues for the tax files.

To determine

Calculate the income tax of Person J for the year 2019.

Explanation of Solution

Computation of income tax for Person L.

Particulars	Amount ($)	Amount ($)
Salary		$ 95,000
Dividends
Interest (1)		$3,500
Award (2)		$1,000
Long-term capital gain (3)		$10,000
Group term life insurance premiums (5)		$54
Other fringe benefits (5)		$ 0
Gross income		$113,554
Less: Alimony paid (6)		($ 6,000)
Adjusted gross income		$107,554
Itemized deductions from AGI
Medical tax (7)	$ 8,833
Charitable contribution	$4,500
Mortgage interest on his residence	$7,200
State and local taxes (8)	$ 10,000	($30,533)
Taxable income		$ 77,021
Particulars	Amount ($)	Amount ($)
Tax on taxable income of $77,021 (9)		$12,278
Tax withheld by employer		($9,500)
Estimated tax payments (10)		($3,000)
Net tax payable		($222)

Table (1)

Notes:

1. 1. The interest amount of $2,000 on the City K’s water bonds is exempted.
2. 2. The amount of $10,000 award from State L for the suggestions for the highway has been included in the gross income of Person J.
3. 3. Compute net of capital gain.

Particulars	Amount ($)
Amount realized from the sale of Company M's stock	$ 45,000
Less: Adjusted basis	($ 41,000)
Long-term capital gain	$ 4,000

Table (1)

Capital gain or losses on inherited property are automatically long-term.

Particulars	Amount ($)
Amount realized on sale of 300 acres of land	$160,000
Less: Adjusted basis	($ 175,000)
Disallowed loss	($15,000)

Table (2)

This loss is disallowed under Section 267 as the sale is made to the related party.

1. 4. Compute the casualty gain or loss:

Particulars	Amount ($)
Person casualty	$16,000
Less: Insurance proceeds	($ 16,000)
Casualty gain or loss	$0

Table (3)

1. 5. The group term life insurance premiums paid by Person J’s employer results in $54$\left(\frac{\$95,000-\$50,000}{\$1,000}\times \$0.10\times 12\text{ months}\right)$ has been included in the gross income of Person J.
2. 6. An amount of $6,000 of alimony paid annually by Person J to Person K is a deduction for AGI.
3. 7. Compute the medical expenses.

Particulars	Amount ($)
Person K’s orthodontic expenses	$4,000
Medical expenses for Person S	$12,900
	$16,900
Less: $\left(\$107,554\times 7.5\%\right)$	($8,067)
Deductible medical expenses	$8,833

Table (4)

1. 8. The total state and local taxes of Person J is $14,500. The maximum amount that is allowed for the deduction of state and local taxes is $10,000.
2. 9. The tax liability has been calculated by using the 2019 tax rate schedule for a single tax payer. Person J has a marginal tax rate of 22%.

   Compute the taxable amount.

Particulars	Amount ($)
Tax on $69,521$\left(\$77,021-\$7,500\right)$:
On $39,475	4,453.50
	$6,610.12
	$11,153
Tax on NCG and dividends $\left(\$7,500\times 15\%\right)$	$1,125
Taxable amount	$12,278

Table (5)

1. 10. Person S is not qualified as a dependent of Person J as Person S does not pass the gross income test. Person K is not qualified as the dependent as Person K is not the custodial parent. As a result of this, Person J may not claim the child tax credit or family credit.

To determine

Draft a letter to Person J by explaining the changes in the general terms for the purpose of income tax and prepare the memo for the tax files.

Explanation of Solution

Letter

September 17, 2019

Person JB

150 Highways 51

City T, LA 70465

Dear Mr. JB

With response to the enquiry related to the structuring the transaction that will enable Person J to use the 300 acres of land in the dairy business. The following two options must be considered:

• Person J should prepay the rent through December 31, 2019. The amount of lease is $12,000 and that is commencing on October 1, 2019.
• The land can be sold for $160,000 which is the fair market value.

The adjusted basis in the land is $175,000 and if that is to be sold to Person J, then the tax results is as follows.

Particulars	Amount ($)
Amount realized	$160,000
Less: Adjusted basis	($ 175,000)
Realized loss	($15,000)
Recognized loss	$0

Table (6)

For further queries, please do not hesitate to contact me.

Sincerely,

Person AS, CPA

Partner

TAX FILE MEMORANDUM

Date: September 10, 2019

From: Person AS

Subject: Sales versus leasing options for Person JB.

Person J owns 300 acres of land that is inherited from Person A during December 2018. The adjusted basis is $175,000 and the fair market value per recent appraisal is $160,000.

Person J and Person JA like to use the land for the diary business. Person J and Person JA have discussed two options. In first option, Person J would sell the land to Person JA for $160,000. In second option, Person J would lease the land to Person JA for $12,000 annually beginning on October 1, 2019. Person J should prepay the rent of $3,000 for the year 2019 and the monthly lease payment should be made in the beginning of the month. The projected income for the year 2019 is $77,021. If the land is leased to Person JA then the taxable would increase by $3,225 in 2019 and by $12,000 in each subsequent year. Person J’s tax rate is presently 22%. The additional tax liability on the $3,225 in 2019 would be $710. Hence, the net cash flow of Person J from the lease would be $2,290. Person J would ascertain that the $12,000 represents the fair rental.