ALAN R. SUMUTKA
ACC-410 FUNDAMENTALS OF FEDERAL TAXATION
CASE 6 - TAX ISSUES OF CHILDREN
“An insisting wife and two people saved my marriage” is how Bill describes it today. Pam knew there was much to be saved and finally persuaded Bill to go to a marriage counselor. It didn’t take many visits for Bill and Pam to recognize the source of their troubles...not enough time devoted to their lives, to their dreams, and to determining their common goals. Too much time devoted to jobs, “things,” and individual goals.
Financially, they were in trouble, which caused some of the stress...always trying to make more to be able to spend more. Bill and Pam made an appointment with a CPA/financial planner, who recommended that they first need to live within their means, not beyond their means. “Every time you bought on credit and didn’t pay off the bill, you were living beyond your means. Obviously, having to pay the 18% interest charge each month really meant that you were paying 118% of the cost (on an annual basis) of everything you bought,” explained the planner. “Plus, you can’t even deduct the interest. The same goes for the car loan and the car lease, where all the finance charges are just built into the lease agreement. And after the three year lease, you don’t even own a car. So back you go to lease another one, right where the car dealers want you! You should be doing what Warren Buffett does. Buy a car and hold it until it dies! You can probably see why you got into financial trouble.”
The planner recommended that they set up a plan to get out of debt and to prioritize their future spending. “In this type of low inflation economy, the only debt you should have is your home mortgage, where the interest is deductible and theoretically, your property is appreciating,” said the planner. “All that other stuff depreciates quickly. Then plan your financial life around four funds: (1) an operating fund, to be used to pay your recurring monthly bills, (2) a reserve/capital expenditure/emergency fund, to be used for unexpected expenditures, “big ticket” items (e.g., autos, appliances, etc.), or if one of you loses a job, decides to quit the workforce, or becomes ill, etc. (otherwise, you have to borrow and put yourself right back into trouble), (3) a retirement fund, where you should invest now and just let the money sit there for years so you get the benefit of compound interest over long periods of time, and (4) if you have children, a college fund to take advantage of many of the tax-favored college savings plans.”
Pam and Bill took all of the advice seriously. They talked and talked and talked. They agreed that they had to spend more time together and they wanted a family. They agreed that they would implement the strategy suggested by the planner, with the first goal to get out of debt and set up three funds for now. Bill would entertain other job offers, especially where he would get more benefits than he had now, and possibly reduce his overtime. Pam, who always had an entrepreneurial spirit, would stay with her current job until the debt was more manageable, then take a maternity leave for their first child, and consider setting up a consulting business at home rather than returning to work.
Two years later, their marital problems were a thing of the past and they had their finances under control. And Lauren was born. And there was a big celebration. And there were plenty of gifts. And Bill and Pam invested the money in Lauren’s name. And each month, they added some of their money to Lauren’s account to save for her college education. And at the end of the year, Lauren had earned $3000 in interest income and $1000 in qualified dividend income. And there were tax issues!
REQUIRED:
PART A: What tests would Bill and Pam have to satisfy to claim
Lauren as a dependent?
PART B: What tax benefits accrue to Bill and Pam as a result of
Lauren? Explain.
PART C: Calculate the amount of tax that Lauren owes for the
current year. (Assume Bill and Pam are in the
28% tax bracket.)
PART D: How could this tax be avoided?
PART E: Do you think it is wise for Bill and Pam to save for
Lauren’s education by contributing their money to Lauren’s college
fund? Explain.