Receiving Money for Purposes of Federal Tax Income - Case Study Example

1a) The issue here is how should the $ 300,000 that John Smith has received for purposes of Federal tax income. For the purpose of United s Federal Income, under Internal Revenue Code ( Title 26), the $ 300,000 that John Smith has received as fee in the settlement of the compensation claim will be treated as the personal income of John Smith. This $ 300,000 will be part of the gross income of John Smith for the previous year whose income is to be assessed for the purpose of Federal income tax. The income of $ 300,000 will be the fee earned for the legal service provided by John Smith to his client in the personal injury case. 1.b) The issue here is how should the expenses of $ 25000 incurred by John Smith in the settlement case be treated for purposes of Federal tax income. The $ 25000 is the recovery of expenses paid upfront by Esq. John Smith in carrying out his business or trade. Therefore this $ 25000 can be deducted as business deduction from the gross income of Esq. John Smith. Business deductions are deductions allowed for business expenses of entities and individuals. 1c) The issue here is: What is the determination regarding reducing the taxable income for both (a) and (b) above. My determination regarding reducing the taxable income of both (a) and (b) above is as follows: Gross income of Mr. John Smith: $ 300,000………………..1 Deduct expenses : $ 25000………………….2 Adjusted incomes ( 1 – 2) : $ 275000………………3 Deduct personal deductions allowed: $ 3650……………..4 Taxable income of Mr. John Smith (3-4)……$ 271, 350. For the year 2010, this taxable income of Mr. John Smith will be charged at the personal income rates if Mr. John Smith elects for treatment as ‘partnership’ of his limited liability company (LLC). It will be charged at the corporate tax rate if Mr. John Smith opts for treatment as a ‘corporation’ of his limited liability company. The lease liability of $ 3500 per month of Mr. John Smith will be reported on the personal income tax returns of if Mr. Smiths opts for the treatment of ‘partnership’ for his limited liability company ( LLC) law firm. It will be reported on the income tax returns of the law practice if John Smith opts for the treatment as a ‘corporation’ of the LLC . The choice regarding this is with John Smith. The property on which he is paying the lease can be depreciated only if he has retention of incidence of ownership in the property. However, if he buys the building then he will get tax advantage in the form of depreciation. So in terms of tax savings it will be more advantageous to buy the building if the allowed deductible depreciation is greater than the amount of lease assuming that this leased property cannot be depreciated currently. If the depreciation is less than the lease then it will not be advantageous to buy the property. 2 a) The issue here is: What are the different tax consequences between paying down the mortgage (debt ) and assuming a new mortgage (debt ) for purposes of Federal income tax? The United States Internal Revenue code allows a home mortgage interest deduction subject to certain conditions (§ 163,Title 26, United States Code ). The payment of principal on the mortgage for the old house of Mr. John Smith and Mrs. Jane Smith, will however be not deductible for the purpose of assessing taxable income. The interest on the new mortgage for acquiring the new house of Mr John Smith and Mrs. Jane Smith will be deductible up to $ 1 million of the debt or up to $ 100,000 of home equity debt regardless of the purpose or use of loan. In the case of Mr. Jane Smith, the tax deduction will therefore be allowed up to $ 1 million of the mortgage debt used to acquire the new house. If Mr. Jane and John Smith choose to sell the old house then they will be allowed exemptions of $ 250,000 ($ 500,000 for couples filing jointly ) on the capital gains allowed from the sale of the old house (§ 163,Title 26, United States Code ). Capital gains are the gains realized from the sale of the asset (house in this case) due to appreciation in the market value of the asset. 2 b) The issue here is: Can John and Jane Smith utilize the 1031 tax exchange to buy a more expensive house using additional money from John’s case? No, John and Jane Smith cannot utilize a 1031 exchange to buy a more expensive house using additional money from the case settlement fee. This is because the properties exchanged must be held for productive use in a trade or business or for the purpose of investment (Section 1031, Title 26, United States Internal Revenue code). Also only like-kind properties can be exchange. Like-kind properties are those that have the same use. A personal property that is used for the purpose of residence does not qualify for 1031 exchange ((§ 1031, Title 26, United States Internal Revenue code). The old house was used for residential purpose by Mr. John Smith and Mrs.Jane Smith and therefore does not qualify for tax deferment under this section 1031 of the Internal Revenue code of the United States of America. 2c.The issue here is: Does Jane have a business or hobby ? Why is this distinction important? Under the Internal Revenue code ( IRC ) of the United States Code ( USC ) an activity is classified as a hobby if it is not engaged into with an objective of profit. The hobby activity is an activity other than the business or investment activity. Under Section 183 (d) of the Internal Revenue code, the presumption of the profit motive is created when the activity has been profitable for three of past five most recent years, including the year at issue. In the case of Prieto versus Commissioner the United States Tax court used the factors listed in Treasure Regulation 1.183-2 to determine whether the activity engaged was one that was engaged for profit or not. Now Mrs. Jane Smith earned $ 20,000 last year. If the motive of Mrs. Jane Smith was to sell for profit then her activity will be classified as a business or trade. Otherwise it will be classified as a hobby. If she had made profits in three of the past five years including the current year then her activity will be definitely classified as trade or business. The distinction is important because under section 165 of the Internal Revenue Code, expenses relating to not-for-profit activities like hobby are not tax deductible for the purpose of computation of taxable income (§ 165, IRC). So any expenses that Mrs. Jane Smith incurs while carrying out the activity of selling jewelry will not be tax deductible. 2 d) The issue here is: Would Jane (and John) realize better tax benefits if she had a separate business for her jewelry making activities? Jane and John would realize better tax benefits if she had a separate business for her jewelry making activity. She would be able to deduct the expenses that she incurs for her activity from her taxable income (§ 162 and 212 of the Internal Revenue Code). 2 e) The issue here is: What tax benefits would John realize if he invested his $ 15000 in Jane’s jewelry making ? If John invests $ 15000 in the jewelry making equipment of Jane he would realize tax benefits in the form of depreciation on the machine in subsequent years ( 26 USC § 179 ). He will also be eligible for deduction of this $ 15000 from his income as first year capital allowance. 2 f. The issue here is : Can Jane depreciate her vehicle or jewelry making equipment ? How ? Under section 1.183-1(b) (1) iii, depreciation is allowed on property used as the basis for the hobby activity. So even if the selling of jewelry is qualified as a hobby, Mrs. Jane Smith can still depreciate her vehicle or jewelry making equipment. If the activity is classified as a business, then obviously she can take the advantage of depreciation on jewelry making equipment and on the vehicle used for the purpose of selling the jewelry. She can depreciate her jewelry equipment using the straight line method. She has to first determine the adjusted basis, the salvage value and the estimated useful life of the equipment and the vehicle. The salvage value, if any, should be subtracted from the adjusted basis. The balance is the total depreciation that Jane Smith can take over the useful life of the jewelry making equipment and vehicle. 3.a) The issue here is: Should John and Jane file separate tax returns or jointly ? Mr John Smith and Mr. Jane Smith should file their tax returns jointly rather than separately. The marginal tax rates for married filing jointly give more scope for tax savings. Also under the Internal Revenue code there is a long list of deductions that are denied under the ‘married filing separately’ status. For example separate filers are not eligible for any of education tax breaks such as the tuition and fees deduction and the hope or lifeline learning tax credits. Therefore, it will be more advantageous for the two to file their returns jointly and not separately. But by filing jointly, they will accept the joint liability for the liabilities arising out of their taxation. The exemption on capitals gains from the sale of house property for married couples filing jointly is $ 500,000 whereas for those filing separately this exemption is only $ 250,000. References: Pratt. James W, Kulsrud. William N, et al. Federal Taxation, New York: Custom Publishing. 2010. Print. Read More