Prepare a three-page memo (at least 1,500 words) to John and Jane Smith addressi
ID: 2384245 • Letter: P
Question
Prepare a three-page memo (at least 1,500 words) to John and Jane Smith addressing the issues presented:
John Smith tax issues:
How is the $300,000 treated for purposes of federal tax income?
How is the $25,000 treated for purposes of federal tax income?
What is your determination regarding reducing the taxable amount of income for both (a) and (b) above?
Is it more beneficial to continue leasing the business space or to buy the building?
Jane Smith tax issues:
What are the different tax consequences between paying down the mortgage (debt) and assuming a new mortgage (debt) for federal income tax purposes?
Can John and Jane Smith utilize a 1031 tax exchange to buy a more expensive house using additional money from John's case?
Does Jane have a business or hobby? Why is this distinction important?
Would Jane (and John) realize better tax benefits if she had a separate business for her jewelry-making activities?
What tax benefits would John realize if he invested $15,000 in Jane's jewelry making?
Can Jane depreciate her vehicle or jewelry-making equipment? How?
John and Jane Smith tax issue:
Should John and Jane file separate or joint tax returns?
You Decide: It's your turn as a tax professional to decide on the best course of action from a tax perspective on their issues as presented above.
For each issue, begin by restating the issue and numbering as shown above [i.e., 1(a), 1(b), etc.]. Next, explain and discuss the tax rules that apply to the issue, which you gleaned from your tax research. Then, conclude with a definitive answer to the issue, supported by citations to the sources used. So for each issue, you should
state the issue;
explain and discuss the applicable law (IRC sections, regulations, court decision, and so forth); and
present your answer in the form of a concluding paragraph that refers to specific language from the IRC sections, regulations, court decisions, and other sources (if applicable) to support the conclusion.
Memo
To: John & Jane Smith
From:
Date: 9/21/2015
Re: Summary of various tax issues
John Smith's Tax Issues:
(a) How is the $300,000 treated for purposes of federal tax income?
Applicable Law & Analysis:
Conclusion:
(b) How is the $25,000 treated for purposes of federal tax income?
Applicable Law & Analysis:
Conclusion:
(c) What is your determination regarding reducing the taxable amount of income for both (a) and (b) above?
Applicable Law & Analysis:
Conclusion:
(d) Do I get better tax benefits for paying the lease on office space or for buying the building? What are the differences?
Applicable Law & Analysis:
Conclusion:
Jane Smith Tax Issues:
(a) What are the different tax consequences between paying down the mortgage debt and assuming a new mortgage debt for federal income tax purposes?
Applicable Law & Analysis:
Conclusion:
(b) Can John and Jane Smith utilize a 1031 tax exchange to buy a more expensive house using additional money from John's case?
Applicable Law & Analysis:
Conclusion:
(c) Does Jane have a business or hobby? Why is this distinction important?
Applicable Law & Analysis:
Conclusion:
(d) Would Jane (and John) realize better tax benefits if she had a separate business for her jewelry making activities?
Applicable Law & Analysis:
Conclusion:
(e) What tax benefits would John realize if he invested $15,000 in Jane's jewelry making?
Applicable Law & Analysis:
Conclusion:
(f) Can Jane depreciate her vehicle or jewelry making equipment? How?
Applicable Law & Analysis:
Conclusion:
John and Jane Smith’s Tax Issues:
(a) Should John and Jane file separate or joint tax returns?
Applicable Law & Analysis:
Conclusion:
Explanation / Answer
Answer:(a) According to Section 61(a) which states that “gross income means all income from whatever source derived, including (but not limited to) the following items: (1) Compensation for services, including fees, commissions, fringe benefits, and similar items;” the $300,000 fee should be included in gross income. The compensation is taxed when is received not when is earned, (John’s fee was earned during 2 year long case), unless a taxpayer uses accrual method to report his/hers income.
Answer:(b) John received, in addition to the $300,000, $25,000 for expenses he incurred during the trial. I would assume that the incurred expenses were deducted and when he was paid the $25,000 it would be considered a reimbursement and it would not be considered income. John paid these expenses out of his pocket and was merely reimbursed for what he spent on the case . In the case of the $25,000, they are not taxable; they should be treated as expenses, meaning that they can be deducted as expenses for that year.
Answer:c John would like to reduce his taxable income. One way to do so is to take advantage of itemized deductions. Itemized deductions include expenses for health care, state and local taxes, personal property taxes (such as car registration fees), mortgage interest, and gifts to charity, job-related expenses, tax preparation fees, and investment-related expenses. As previously mentioned in answer number 1, Mr. John Smith should choose the annuity payments options, in order to reduce the chances of lawsuit taxation in the case of the large settlement for the $300,000. In regards to the $25,000, as mentioned before, they need to be treated as expenses and deducted from his income tax.
Answer:d
Jane Smith Tax Issues:
(a) What are the different tax consequences between paying down the mortgage debt and assuming a new mortgage debt for federal income tax purposes?
Answer:(a)For tax purposes, we are allowed to deduct only the mortgage interest. So the only difference for the tax purposes would be the amount of interest that can be deducted.
(b) Can John and Jane Smith utilize a 1031 tax exchange to buy a more expensive house using additional money from John's case?
Answer:(b)Code § 1031 , the exchange of certain types of property may defer the recognition of capital gains or losses due upon sale, and hence defer any capital gains taxes otherwise due. To qualify for Section 1031 of the Internal Revenue Code , the properties exchanged must be held for productive use in a trade or business or for investment.
Conclusion: Since this home would be for personal use and not business use it will not qualify for the 1031 tax exchange. The way that they would be able to utilize a 1031 tax exchange would be if they were buying it as a new business for either John’s work or Jane’s work.
Issue c) Does Jane have a business or hobby? Why is this distinction important?
Answer:(c)Code § 183 - in making the distinction between a hobby or business activity, all facts and circumstances with respect to the activity are taken into account.
Conclusion: According to the IRS, a hobby is engaged in for personal pleasure, with little or no profit motive. Hobbyists would do their activity regardless of whether they made any money or not.A business, on the other hand, is engaged in for profit. The income is shown on the tax return and the expenses are netted against it. In this case since Jane earned $20,000 of income from her handcrafted jewelry, this could be considered a business for tax purposes. The standard rule of thumb is to show a profit in 3 of the last 5 years. Factors listed in Treasury Regulation sections 1.183-2(b) that the IRS considers: • The manner in which the taxpayer carries on the business--good records. • The expertise of the taxpayer or his advisors. • The time and effort expended by the taxpayer in carrying on the activity. In general, taxpayers may deduct ordinary and necessary expenses for conducting a trade or business. An ordinary expense is an expense that is common and accepted in the taxpayer’s trade or business. A necessary expense is one that is appropriate for the business. Generally, an activity qualifies as a business if it is carried on with the reasonable expectation of earning a profit.
(d) Would Jane (and John) realize better tax benefits if she had a separate business for her jewelry making activities?
Answer:As a self-employed individual, generally you are required to file an annual return and pay estimated tax quarterly. Jane could also be responsible for self-employment taxes. SE tax is a Social Security and Medicare tax primarily for individuals who work for themselves. It is similar to the Social Security and Medicare taxes withheld from the pay of most wage earners. It may be beneficial for Jane to create a separate business for her jewelry-making activities .
(e) What tax benefits would John realize if he invested $15,000 in Jane's jewelry making?
Answer:(e) If John were to invest in the company, he would qualify for tax benefits. For example, his income from the disposition of his portion of the company, like selling his shares, would be subject to the 50% exclusion of gain rule.
(f) Can Jane depreciate her vehicle or jewelry-making equipment? How?
Answer:(f) The IRS allows for the depreciation for the business use of personal property. Jane can deduct the cost of operating and maintaining her vehicle, including mileage to and from clients. She can also deduct expenses related to the use of her home for business purposes. That would include depreciation on the percentage of the home that she uses exclusively for business, like an office. She can also deduct a portion of her home expenses related to the business, like a percentage of her electric bill. She would be eligible for these deductions so long as she meets the “Exclusive use”, “Regular Use”, and “Principal place of business” tests. If her gross income from the business is greater than her total business expenses, she can deduct all of her expenses. However, if her gross income is less than the total business expenses, certain expenses for the personal use of her home would be limited (Business Expenses).
John and Jane Smith’s Tax Issues:
(a) Should John and Jane file separate or joint tax returns?
Answer:(a)John and Jane should file a joint return. Together, they would have a greater amount of deductions and exemptions that would better lower their tax liability.