Federal Tax Week 3 You Decide

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1. John Smith's tax issues:

Issue a) How is the $300,000 treated for purposes of federal tax income?

Applicable Law & Analysis:
From the information that was provided, the income was derived from the business and this gross income is taxable pursuant to Code§1.61-3(a). He is subject to self-employment tax, since the total amount of income that will come through to his personal tax income of half of the self-employment tax liability.

John will have to pay self-employment tax, which is the gross income that obtained in business in the amount of $300,000. He will actually have to pay "income" and "self-employment" tax on the "net" earnings from his business... not the entire $300K because presumably he has business deductions.

Issue b) How is the $25,000 treated for purposes of federal tax income?

Applicable Law & Analysis:
The $25,000 is the reimbursement John for the expenses that were paid in advance for this client. Under Code§1.61-3(a), the funds are considered as incidental income. John would have to maintain the receipts from the expenses that he has incurred so that the proceeds will have a balancing deduction. The expenses were necessary for his business and he will be able to deduct the full amount.

John will have the $25,000 included in the gross income. However, he will be able to deduct the full amount because they were expenses for the business. good

Issue c) What is your determination regarding reducing the taxable amount of income for both (a) and (b) above?

Applicable Law & Analysis:
John will have self-employment tax to pay. He will also have the $25,000 added to the gross income. He will be able to deduct the expenses. Since, John is self-employed; he may want to look into investing in a retirement plan to reduce the taxable amount < good! . Under Code§219(f)(3), John would be able to establish a retirement program and receive a tax deduction each year of $10,000 < where did you get this number from?. He will also be able to contribute to Jane’s retirement since she makes minimal income. < not necessarily.


My recommendation to lowering the taxable is participating in a retirement plan. The taxable amount is lowered because taxes are not taken out until after the investment is deducted from gross income. You should have suggested that he identify all ordinary and necessary business expenses. You might have him consider an acceleration of itemized deductions or the purchase of new office equipment or other assets used in his business that he can write-off under IRC 179.

Issue 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:
John is currently making lease payments in the amount of $42,000 per year, which is taxable deductible under Code§162(a). He does not own the building or will not be able to use the equity. If he decides to purchase the building, he will not be able to use the building as a deduction because this is considered a capital purchase. He will also be subject to depreciation expenses.

In summary, I would advise John to continue to lease the building. He will continue to receive deductions for leasing the building. You should suggest that you need more information to provide an analysis of the cost/benefit of purchasing vs. renting. The rents are deductible if continues to rent. If he buys, the basis of the building will be depreciable over 39 years and he will be able to deduct mortgage interest, real estate taxes and all other ordinary and necessary operating costs.

2. Jane Smith tax issues:

Issue 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:

The sale of their home every two years can produce a gain of up to $500,000 may be excluded to...
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