Scenario:
You are a CPA with an office in NearLakes City and clients consisting primarily of professionals, entrepreneurs, and small business owners. John Smith, Esq., a practicing attorney with offices near yours, walks in your office and wants advice from you relating to a recent influx of cash he received as a result of winning a large jury verdict on behalf of his client in a personal injury case. His wife Jane Smith accompanies him during your meeting because she has some additional tax planning advice to ask of you.
John Smith—Lawyer
I worked on this case for over two years. The jury awarded my client $2,000,000 in damages, of which my fee was $300,000 plus recovery of expenses paid up front in the amount of $25,000. How is the $300,00 taxed? What about the $25,000? What can I do to minimize the tax consequences or each? Also, I am thinking about buying the building that I currently lease my office space in. My current lease is $3,500 per month. How is this lease reported on my income tax returns (either personally of for my business which is a separate law practice established as an LCC)? Do I get better tax benefits for paying the lease or for buying the building? What are the differences?
Jane Smith—Wife
I think that the fees would be better used for paying off our house and buying a new, bigger house that I?ve had my eye on. Does it make better sense for us to pay off the mortgage, sell the house, and buy a new house, or should we just use the money to buy new house after selling the old house? Also, I sell handcrafted jewelry which earned me $20,000 last year. Do my business activities constitute a trade or business for federal income tax purposes? Or is this just a hobby? Should I establish a separate trade or business to get tax benefits on these earnings? Does it make any difference that I use my car primarily for transporting my jewelry to different shops around town? Finally, I think I can earn more money if John were willing to invest $15,000 for new jewelry making equipment since my original equipment which cost $10,000 five years ago, is almost obsolete. Does this make sense from a tax perspective?
Role:
After reviewing John and Jane Smith?s points of view, it will be your turn as a tax professional to decide on the best course of action from a tax perspective on their issues.
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?
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 tax returns or jointly?
