John and Jane Smith
Memo summarizing various tax issues
1. John Smith's Tax Issues
Issue (a): How is the $300,000 treated for purposes of federal tax income? The $300,000 is treated as business income. After deducting all of the business expenses, the remaining amount will be the taxable income. Lawyers either work on a salary in a big law firm, or work directly with clients and collect the fees from these clients. If it is a salary, then it will be taxed the same way as ordinary income in the W-2 form, and if it is a business income like in our situation here with John, then it will be treated as a self-employment income that will be taxed after deducting any business expenses. The $300,000 is included in John’s Gross Income. Section 61 of the IRS Tax code generally defines gross income as all income from whatever source derived, including the compensation for services, fees, commissions, fringe benefits and similar items. Therefore the $300,000 is classified as compensation John received for legal services rendered.
Issue (b): How is the $25,000 treated for purposes of federal tax income? The 25,000 is treated as an income and at the same time as a business expense. The $25,000 should be included in John’s income since he received it, while he still can claim this amount as a business expense, so he will be taxed on this amount.
Issue (c): What is your determination regarding reducing the taxable amount of income for both (a) and (b) above?
In order for John to reduce the taxable amount of his income of $300,000, he must maximize his deductions as business expenses. Business expenses are the cost of carrying on a trade or business. Expenses are usually deductible if the business is operated to make a profit. The tax code Section 162- Trade or business expenses indicates for a business expenses to be deductible, it must be both ordinary and necessary. An ordinary expense is one that is common and accepted in the business, while a necessary expense is one that is helpful and appropriate for the business. The other requirements for an expense to be deductible as a business expense include, it being reasonable in amount and practice; an expense is allowable as a deduction only if it is paid and incurred during the taxable year. Business expenses are deductible for adjusted gross income. They are deducted in computing John AGI on Schedule C of John and Jane Tax returns.
Section 162 of the tax code indicates that John business expenses deductible could include traveling expenses, which is consists of amounts expended for meals and lodging, while away from home in the pursuit of business. The $25,000 has been used already as business expenses, so it is not taxable income. The $300,000 is considered a lump sum payment for two years of work on this case; therefore John needs to see what his best option to report this income is. If John reports his income in one year, that will put him in a higher tax bracket. The more income you make, the higher taxes you pay, so the better option is to review last year’s tax return and compare the tax rate of each year to see how much taxes will be withheld.
Issue (d): Do I get better tax benefits for paying the lease on office space or for buying the building? What are the differences?
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2. Jane Smith’s 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? Paying down the mortgage and assuming a new mortgage will not change the fact that the $300,000 is an income to John and Jane. Buying a bigger house has the same tax benefits as keeping the old house, where they can deduct the mortgage interest and real estate taxes from income earned. Married taxpayers can exclude up to $500,000 of gain upon the sale of the house.
On the other hand, if they use the money to buy the...
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