Tax professional perspective on John Smith's financial issues and recommended actions

Tax Liability

Opening: This memo concerns the income tax questions for John and Jane Smith, a married couple. John is a lawyer and has questions regarding income to his firm, investment in office space, and overall preparation techniques. Jan has questions regarding business related activities, real estate investments, business expenses, and business investments.

John Smith

How is the $300,000 treated for purposes of Federal Tax income?

Under 26 U.S.C. Section 1402, "The term "net earnings from self-employment" means the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss described in section 702 (a)(8) from any trade or business carried on by a partnership of which he is a member"

All income earned during a business year is considered business income. This includes the $300,000 contingency fee. Under IRS Law, income can be spread out up to two years in the future or amended back up to 3 years. In the case of the $300,000 contingency fee, it would be more advantageous for John to amend this previous two returns and include $100,000 for each year he has been working on the case. This will lower his overall tax liability. The only question is the amount earned in prior years. Should the amount earned in the prior years along with the filing result in too high an amount, then the remaining income may be more beneficially paid in the present tax year.

1b. How is the $25,000 treated for purposes of Federal Tax income?

Under 26 U.S.C. Section 162, "There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including

(1) a reasonable allowance for salaries or other compensation for personal services actually rendered;

(2) traveling expenses (including amounts expended for meals and lodging other than amounts which are lavish or extravagant under the circumstances) while away from home in the pursuit of a trade or business; and (3) rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity."

The full $25,000 was out-of-pocket costs for the business. Under IRS law, business costs are directly credited and no taxes are owed. In other words, there will not be any tax liability owed for the $25,000.

1c. What is your determination for reducing the taxable amount of income for both (a) and (b) above?

The optimal way to reduce taxable income for the $300,000 contingency payment is to amend the previous two-year's taxes to reflect the amount earned for each year respectively. This can either be done in equal parts for all three years or divided into amounts based on hours spent on the case.

The $25,000 is reimbursement of a business expense and will be directly canceled out on the current taxes. With regard to this expense, make certain that all expense related documentation is saved and the expenses broken down on the tax form.

Jane Smith

2a. What are the tax consequences between paying down the mortgage and assuming a new mortgage for tax purposes?

Jane's question is regarding whether it is more beneficial to either pay off their current mortgage, sell their old home and buy a new home, or purchase the new home with the proceeds from the sale of the first home and any additional funds would come from John's income.

According to the 1997 Tax Payer Relief Act, "Gross income shall not include gain from the sale or exchange of property if, during the 5-year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer's principal residence for periods aggregating 2 years or more."

In other words, when these three requirements are met, a homeowner is not liable for the profit gained in the sale of a home. The first condition is that the couple lived in the home for at least two years. Second was that the home was a primary residence. This means that the home must have been the place the couple lived exclusively for two years. Finally, this rule applies so long as no other tax-free property sales were completed within the last 2 years.