Gerry is the sole shareholder and president of Garmon Corporation. He also owns the office building that serves as the corporation's headquarters. Last year, Garmon paid Gerry $250,000 for the use of the building. Garmon's MTR was 21% and Gerry's was 37%. The revenue agent who audited Garmon's return has concluded that the fair rental value of the office building was $200,000. What is the net impact of this audit conclusion on Gerry and Garmon's combined income tax liability?

Question

Quizplus · Accepted Answer

The issue at hand is whether the $250,000 paid by Garmon to Gerry for the use of the office building is a reasonable and fair rental value, given that Gerry is the owner of the building and the sole shareholder of Garmon.

The revenue agent has concluded that the fair rental value of the office building is $200,000. This means that Garmon should have paid only $200,000 to Gerry, and the remaining $50,000 constitutes excessive rent that benefits Gerry personally.

Therefore, the $50,000 should be reclassified as a constructive dividend to Gerry, on which he will pay tax at his individual MTR of 37%. Garmon's deduction for rent will be reduced by $50,000, resulting in an increase in taxable income.

The net impact of this audit conclusion on Gerry and Garmon's combined income tax liability can be calculated as follows:

Gerry's additional tax liability = $50,000 x 37% = $18,500

Garmon's reduced deduction = $50,000 x 21% = $10,500

Therefore, the net impact is a $2,000 increase in tax liability ($18,500 - $10,500 = $8,000, which is divided equally between Gerry and Garmon).

Therefore, the correct answer is C.

Gerry Is the Sole Shareholder and President of Garmon Corporation