1 (A) The question is how should a $300,000 fee collected by John Smith after two years of work on a personal injury case with a $2,000,000 jury verdict in his clients favor, be reported for tax purposes. Under Internal Revenue Code (IRC) 61, section (a) subsection (1) gross income is defined as “Compensation for services, including fees, commissions, fringe benefits, and similar items. ” This section of the tax code is very comprehensive (with 15 descriptive subsections) to almost all forms of income with very few exceptions.
This has also been held up by the supreme court in numerous cases including the land mark Eisner v. Macomber, 1 USTC p32,252 U. S. 189, 40 S. CT 189 (1920). This $300,000 fee you appear to have collected must be included on your income tax as gross income. As attorney you have to claim this money on your personal income tax form 1040 by attaching a schedule C sole proprietorship profit or loss form. In some states an attorney practicing as a single member LLC would have to report this money as gross income on an LLC tax return. 1 (B)
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The question is how should the reimbursement of $25,000 paid up front by John Smith during his two years of work on the mentioned personal injury case, be reported for tax purposes. The IRS is well aware of the common practice by attorneys to pay litigation expenses on behalf of their clients, especially in “contingency fee” cases. These expenses should be treated as a loan when incurred to be collected by the client at a time in the future according to Herrick v. Commissisioner, 63 T. C. 562, 569 (1975) (discussing Burnett v. Commissioner, 356 F . 2d 755 (5th Cir. 966). . They are defined more specifically in Canelo v. Commissioner, 53 T. C. 217, 219 (1969) aff/d 447 F. 2d 484 (9th Cir. 1971) to include: travel expenses, costs of medical records, reports, interpreters’ fees, witness fees, deposition costs, filing fees, investigation costs, photographs, laboratory tests and sheriffs fees for service. Also, according to IRC section (a) “Gross income does not include income attributable to the recovery during the taxable year of any amount deducted in any prior taxable year to the extent such amount did not reduce the amount of tax.
Putting all of that together, if you/John had expensed the $25,000 in the year that you had paid out this money then it would have to be added to gross income you must report for on this year’s tax returns. If however, you did not deduct these expenses from previous year,s tax returns then this $25,000 would be treated as a non-taxable repayment of a loan and can be left off of your tax forms entirely. 1 (C) How would I determine to reduce the tax liability for both the $300,000 fee and $25. 000 reimbursement of expenses?
IRC 1361 section (a) S corporation defined, subsection (1) An S corporation is defined as a small business corporation. Section 301. 7701-3 subsection (a) allows a business entity that is not classified as a corporation to elect this classification. This includes an S corporation classification. My determination is that John should operate as an LLC with S corporation status which would allow him to avoid taxation on any portion of his income for which he does not draw in a pay check. This status would require him to file his tax returns using form 1120S. 2. Jane Smith tax issues: 2 (A).
What would be the tax consequence for paying down a current mortgage versus the tax consequences for assuming a mortgage on a new home? IRS Publication 523 states that taxpayers can exclude up to $500,000 of gain upon the sale or exchange of their primary residence for once every two years. Whether or not you both choose to buy another home I would suggest you to leave the bulk of income from Johns law practice as capital in his law practice while it exists as an LLC operating as an S corporation. If you do choose to buy another home later you can use your saving towards the new home.
Most importantly do not pay down the mortgage on your current home but rather use the money towards your next home which would give you a higher basis in that home and therefore reduce your capital gains in the first home and also in the possible second home. 2 (B) Would John and Jane be able to b. Can John and Jane Smith utilize a 1031 tax exchange to buy a more expensive house using the extra money from John’s case? Internal Revenue Code 1031 is intended for exchanges involving property held for investment and not a personal residence.
Quoting from the IRC “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment. ” Since 1031 is intended for business assets you would not be allowed to use this tax break on the purchase of the next home you will live in. 2 (C) Jane wants to know if the money she makes selling handcrafted jewelry constitutes a business or a hobby and why it is important to make that distinction.
IRC 183 states in part “a hobby can not generate a tax loss that can be used to offset other taxable income on your tax return. ” Considering that your hobby is also costing you money (such as $10,000 on previous equipment) and as the business grows you may wish to offset any losses from your jewelry business against profits in your husband’s law firm, it would be to your advantage to count your profits from selling jewelry as a business so that you can take advantage of future tax benefits. (D) Is there a greater tax advantage for Jane and John if her jewelry business was established as a separate business from his. My answer is that when John incorporates his LLC as an S corporation he should write it in his articles of incorporation that her business is a separate entity owned by his. This way any losses incurred by her business can act against the profits of his law firm and in that way reduce their tax liability, saving them money on their taxes. 2 (E) If John were to invest $15,000 in Jan’s jewelry making what would be the tax benefits to doing so?
My answer is yes, because you would be taking money that only serves as taxable profit from the larger business and placing it as an expenditure into the smaller business. This business expense could then be deducted against profits in that business which would reduce their tax liability overall. 2 (F) Can Jane reduce her tax liability by utilizing the depreciation of both her car and her jewelry making equipment? If so how? IRS Topic 510 states if you use your vehicle solely for the use of a business you can deduct 100% of the expenses and depreciation of that vehicle towards the business.
Let’s say for example you use 70% of your miles driving the car for your business, then you can deduct 70% of those expenses against your business profits. There is also a standard mileage rate to go by but either way you must keep track of your miles driven for work and not for work. For the equipment, IRC 179 allows you two methods of depreciation on the books. You can deduct the cost of the equipment as onetime expense for the year you first place the equipment in service. Your other option is to depreciate the asset yearly against profits in the business. 3.
John and Jane Smith tax issue: Should the two of you file spate tax returns or one joint tax return? My advice it for the both of you to file the same return together with Johns law firm as an LLC acting as an S corporation in ownership of your jewelry making business. This way you can average out your income on a “married filing jointly return” as well as deducting any losses from Jane’s business against John’s law firm. This will reduce your tax liability the greatest since you are both healthy and there are not major medical deductions or reasons that I can see for a separate returns.