Prepare a three-page memo (at least 900-1,500 words per page) to John and Jane Smith addressing the issues presented:
1. John Smith tax issues:
a. How is the $300,000 treated for purposes of federal tax income? b. How is the $25,000 treated for purposes of federal tax income? c. What is your determination regarding reducing the taxable amount of income for both (a) and (b) above? d. Is it more beneficial to continue leasing the business space or to buy the building?
2. Jane Smith tax issues:
a. What are the different tax consequences between paying down the mortgage (debt) and assuming a new mortgage (debt) for federal income tax purposes? b. Can John and Jane Smith utilize a 1031 tax exchange to buy a more expensive house using additional money from John’s case? c. Does Jane have a business or hobby? Why is this distinction important? d. Would Jane (and John) realize better tax benefits if she had a separate business for her jewelry-making activities? e. What tax benefits would John realize if he invested $15,000 in Jane’s jewelry making? f. Can Jane depreciate her vehicle or jewelry-making equipment? How?
3. John and Jane Smith tax issue:
a. Should John and Jane file separate or joint tax returns?
To:John & Jane Smith
Re:Summary of various tax issues
Your first question is how is the $300,000 treated for purposes of federal tax income? In Code 61(a), income derived from services is one of the listed forms of taxable income.i This includes fees, commissions, fringe benefits and similar items. Since the compensation was earned this year, even though you worked on the case for two years, you will include it as ordinary income this year.
You can reduce your tax liability by deducting necessary business expenses that were paid in the same tax year. Code Sec 162(a).ii Any salaries or compensation paid to others, travel expenses, which include meals and lodging that are not excessive, or other trade expenses can be deducted against your income.
You also received $25,000 to recover expenses. Reimbursed expenses are not taxable. Sec 162( a)(1)(A)iii providing that you furnished your client with a list of expenses that were reimbursable and any remaining amount was given back. Any amount that was not refunded to the client that exceeded the reimbursable amount is taxable. Sec 162(c)
If you did not furnish a list of expenses to your client the $25,000 will be part of your gross income and the expenses can be deducted.
If you purchase an office building you are allowed to take a depreciation expense against the basis of the building for wear and tear. iv The actual cash paid is not deducted when it is paid. An office building would be Section 1250 property and depreciable over 27.5 years.v Interest on the office building mortgage would also be tax deductible but the mortgage would eventually be paid off and you would not have that deduction any more.
The full amount of the lease is tax deductible as it is a necessary business expense. Sec 162(a). Since your lease is $3,500 a month, you can deduct $42,000 a year for the lease expense. It can be deducted every year you are leasing the building. You would have to buy a building that costs more than $1 million to get close to the same annual deduction. It is more beneficial for you to continue to lease the office building you are in.
Mortgage interest can be deducted as an itemized deduction on Schedule A.vi The deduction can be taken on your first or second home on the interest on loans up to $1 million since it was purchased after October 13, 1987 and the loan is secured by the house. Extra interest on an additional $100,000 can be deducted for home equity loans. Rev Rul 2010-25. The second residence must be used for at least 14 days or 10% of the number of days if it is rented out. If you pay down the debt before you get a new mortgage, you could potentially lose out on some of the mortgage interest deduction.
When you sell your personal residence, Cod Sec 121 allows you to exclude $500,000, or $250,000 if filing separately, of the gain on the sale since you have owned and occupied the home for two out of the last five years.
You are not eligible to utilize a 1031 exchange. A 1031 exchange is for property held for production in a trade or investment purposes. Personal residences do not qualify.vii A 1031 exchange is for deferring taxes on capital gains and depreciation recapture on business property.
Section 61(a) also includes hobby income in taxable gross income. The $20,000 that you made from selling the jewelry you hand crafted is considered income from a trade because your motive is to make a profit. IRS Publication 535 also outlines that making jewelry is a business because of the time and effort put into it and that you expect to continue to make a profit from it.
If you want to keep the jewelry as just a hobby you can only deduct expenses to the extent of your income under Section 183.viii You could not make jewelry with the intent to make a profit. You would be much better off if you keep the jewelry as a separate business so that you could take business deductions in excess of your income. As a hobby, you would lose out on depreciation and other expense deductions beyond your income. Hobby deductions are only taking on Schedule A. If you have a year that you do not have enough to itemize your deductions you would lose out on all of the business expenses.
It would also be beneficial to set up a limited liability company. (LLC) A LLC limits the partner’s liability to your basis in the company and will protect your personal assets and is disregarded for tax purposes. You would also avoid paying self-employment taxes if you were a sole proprietor and report on a Schedule C. Instead, you can pay yourself a wage and the employer part of your taxes would be deductible.
If John were to invest $15,000 into Jane’s jewelry business he would not have a tax deduction or benefit until he sold the stock or the business became worthless. Under Sec 1202ix, 50% of the gain on the sale of his stock would be excluded.
Also, under Section 1244, if the stock becomes worthless John could take an ordinary loss deduction instead of a capital loss deduction which is limited to his capital gain income.
Jane can also take a depreciation deduction against her personal vehicle under Section 168(c). Jane will need to keep records of vehicle use for business purposes. The cost of operating and maintaining can be apportioned between business and personal use.
Some of your home expenses can be deducted as a home office since Jane’s principal place of business is in your homex. Although home office deductions are limited to the business income, they excess can be carried forward to the next year. Make sure you keep records of your utilities that are used for your business and they can be apportioned between personal and business use. Partial depreciation can also be taken on your home.
You should file a joint return as married filing jointly taxpayers get more tax benefits. Your tax liability could be lower than your tax liability combined if you file married filing separately.