Question

Problem 7-35 (LO. 3, 4) On July 24 of the current year, Sam Smith was involved in an accident with his business use automobile. Sam had purchased the car for $30,000. The automobile had a fair market value of $20,000 before the accident and $8,000 immediately after the accident. Sam has taken $20,000 of depreciation on the car. The car is insured for the fair market value of any loss. Because of Sam's history, he is afraid that if he submits a claim, his policy will be canceled. Therefore, he is considering not filing a claim. Sam believes that the tax loss deduction will help mitigate the loss of the insurance reimbursement. Sam's current marginal tax rate is 35%. a. Complete the letter to Sam that contains your advice with respect to the tax and cash-flow consequences of filing versus not filing a claim for the insurance reimbursement for the damage to his car. Maloney, Young, Nellen, & Persellin, CPAS 5191 Natorp Boulevard Mason, OH 45040 January 27, 2021 Mr. Sam Smith 450 Colonel's Way Warrensburg, MO 64093 Dear Mr. Smith: This letter is to inform you of the tax and cash-flow consequences of filing a claim versus not filing a claim with your insurance company for reimbursement for damages to your business-use car. If an insurance claim is filed, you will have a taxable gain 2,000 This is determined by computing the difference between the insurance proceeds ✓ and the lesser of the adjusted basis or decrease in FMV . The result will produce a net cash flow of $ 11,300 of $ If no insurance claim is filed, you will have a deductible loss of $ 10,000, which will reduce ✓ your tax liability by $ 3,500 The net cash benefit resulting from filing an insurance reimbursement claim would be $ 7,800 Should you need more information or need to carify anything, please contact me. Sincerely, John J. Jones, CPA Partner

Answer 1

Hoffman, Maloney, Raabe, and Young, CPAs

5191 Natorp Boulevard

Mason, OH 45040

January 27, 2021

Mr. Sam Smith

450 Colonel’s Way

Warrensburg, MO 64093

Dear Mr. Smith:

This letter is to inform you of the tax and cash flow consequences of filing a claim versus not filing a claim with your insurance company for reimbursement for damages to your business use car.

If an insurance claim is filed, you will have a taxable gain of $2,000 computed as follows:

Insurance recovery                                                                                  $ 12,000

            Less: Lesser of adjusted basis of $10,000

                      or decline of FMV of $12,000                                            (10,000)

            Gain                                                                                            $   2,000

This will produce a net cash flow of $11,300 computed as follows:

Insurance reimbursement received                                                           $12,000

                                    Less: Tax on gain (35% × $2,000)                                                     (700)

Net cash flow                                                                               $11,300

If no insurance claim is filed, you will have a deductible loss of $10,000, which will reduce your tax liability by $3,500 (35% × $10,000).

The net cash benefit resulting from filing an insurance reimbursement claim would be $7,800 ($11,300 − $3,500).

Should you need more information or need to clarify anything, please contact me.

Sincerely,

John J. Jones, CPA

Partner

TAX FILE MEMORANDUM

January 27, 2021

From:               John J. Jones

Subject:           Tax consequences for Sam Smith if he does not file an insurance claim for reimbursement for damages to his business use car

If an insurance claim is filed, Sam will have a taxable gain of $2,000 computed as follows:

Insurance recovery                                                                  $ 12,000

Less: Lesser of adjusted basis of $10,000 or  

decline of FMV of $12,000                                  (10,000)

              Gain                                                                                        $   2,000

This will produce a net cash flow of $11,300 computed as follows:

                                    Insurance reimbursement received                                               $12,000

  Less: Tax on gain (35% × $2,000)                                                     (700)

Net cash flow                                                                               $11,300

If no insurance claim is filed, Sam will have a deductible loss of $10,000, which will reduce his tax liability by $3,500 (35% × $10,000).

In my correspondence with Sam, I pointed out that the net cash benefit from filing an insurance reimbursement claim would be $7,800 ($11,300 − $3,500).