Lakes Tax Research Memo Personal Injury Winning

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Tax Research Memo

Personal Injury winning treatment and other issues research

XYZ CPAs

NearLakes City

John Smith tax issues

Treatment for purposes of Federal Tax Income of $300,000 fee received out of the amount awarded by Jury.

Applicable Law:Any winnings in a personal injury lawsuit that cover the treatment of physical injuries are not taxable except for attorney fees which are taxable. IRC SEC 104(a)(2).Taxability also depends upon the place of residence of the taxpayer.

$300,000 received by John Smith as fees from jury award is taxable for federal tax income purposes.

Treatment for purposes of Federal Tax Income of $25,000 expenses paid upfront and received out of the amount awarded by Jury.

Applicable Law: Any winnings in a personal injury lawsuit that cover the treatment of physical injuries are not taxable except for attorney fees which are taxable. IRC Sec 104(a)(2).Any expenses can be claimed as a deduction.Taxability also depends upon the place of residence of the taxpayer.

Conclusion:Expenses paid upfront and received as part of the jury award can be claimed as a deduction in the hands of the recipient.

1c

Issue: Reducing the taxable amount of income for both (a) and (b) above.

Applicable Law:An annuity payment in contrast to a lump sum receipt can reduce the taxation amount.

Conclusion:If there is an option to choose the form of payment i.e. An annuity or a lump sum payment, it is better to choose the option of an annuity payment as it can reduce the amount of taxation.

Jane Smith tax issues:

2a

Issue: Different tax consequences between paying down the mortgage (debt) and assuming a new mortgage (debt) for Federal income tax purposes

Applicable Law:

Conclusion:It is better to take a new mortgage only in case where the new one offers a rate of interest which is lower than the old one. Otherwise, there is not much sense in taking a new mortgage.

2b

Issue: 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:As perSec 1031 under IRC, a tax payer qualifies to defer the recognition of the capital gains tax on a property which is exchanged for another. However, to qualify for this section, the properties exchanged must be like-kind and used for a trade or business or for investment.

Conclusion:In this case, the property exchanged is a house and not one used in any trade, business or for investment purposes. Hence, it does not qualify for Sec 1031 tax exchange.

2c

Issue: Does Jane have a business or hobby? Why is this distinction important?

Applicable Law:Any activity which is carried with the intention of earning any income will be classified by the IRS as a business and taxed accordingly. Sec 61 of IRS.

Conclusion:The distinction between hobby and business is important to determine the taxability of the profits earned from such activity. The nature of activity shows that it is a business. By classifying it as a business, you will be able to deduct the associated expenses on Schedule C. The IRS will make use of the "3 of 5" rule to determine if it is a hobby or a business i.e. If the business has made profits in three out of past five consecutive years.

2d

Issue: Would Jane (and John) realize better tax benefits if she had a separate business for her jewellerymaking activities?

Applicable Law:Expenses of a small business can be claimed on Form1040 Schedule A.

Conclusion:Yes, it would be better as you can claim first year expense deduction for equipment purchased, claim expenses and deduct your business losses.

2e

Issue: What tax benefits would John realize if he invested $15,000 in Jane's jewellery making?

Applicable Law:Section 179 of the IRS deals with expensing of certain assets in the first year of their purchase.

Conclusion:It can be claimed as a first year expense deduction.

2f