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COLLINS ACCOUNTING SERVICES
INTEGRITY, EFFICACY, EXPERIENCE
4/25/12
To: John Smith, Jane Smith From: Leisha Collins, CPA, CTP On February 26, 2012, subsequent to the recent influx of cash, received by Mr. John Smith as a result of winning a large jury verdict in a personal injury case, Mr. Smith, accompanied by his wife, Mrs. Jane Smith, sought tax planning advice from Collins Accounting Services. After a cursory review of the vantage points of Mr. and Mrs. Smith, Collins Accounting Services has drafted the following response to all pertinent issues raised during our initial consultation. Mr. John Smith raised three issues: (1) How is the $300,000 treated for purposes of Federal tax income? (2) How is the $25,000 treated for purposes of Federal tax income? (3) What is your determination regarding reducing the taxable amount of income for both (1) and (2) above? Mrs. Jane Smith raised six issues: (4) What are the different tax consequences between paying down the mortgage (debt) and assuming a new mortgage (debt) for Federal income tax purposes? (5) Can John and Jane Smith utilize a 1031 tax exchange to buy a more expensive house using additional money from John's case? (6) Does Jane have a business or hobby? Why is this distinction important? (7) Would Jane (and John) realize better tax benefits if she had a separate business for her jewelry making activities? (8) What tax benefits would John realize if he invested $15,000 in Jane's jewelry making? (9) Can Jane depreciate her vehicle or jewelry making equipment? How? Mr. and Mrs. Smith raised one issue concerning both parties: (10) Should John and Jane file separate tax returns or jointly? Issue 1 How is the $300,000 treated for purposes of Federal tax income? Synopsis The $300,000 received as a result of winning a large jury verdict in a personal injury case is treated as ordinary income. Explanatory Detail Internal Revenue Code Section 61 (a) indicates that Gross Income includes all income from whatever source derived unless specifically exempted by law. In the case of L.W. Ross,482 USTC 9341,169 F.2d 483 (CA1 1948),the courts have
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Collins Accounting Services 9002 Near Lakes City Blvd Ste. 400 Near Lake City, MI 40451 Office: (404) XXXXXXX Email: [e-mail]
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ruled that once the individual has an "absolute right" to the compensation, the amount of the remuneration must be included in the taxpayer's income. Publication 525 from the Internal Revenue Service require a taxpayer to report compensatory damages as ordinary income if any of the following instances are met: Interest on any award. Compensation for lost wages or lost profits in most cases. Punitive damages, in most cases. It does not matter if they relate to a physical injury or physical sickness. Amounts received in settlement of pension rights (if you did not contribute to the plan). Damages for Patent or copyright infringement, Damages for Breach of contract Damages for Interference with business operations. Back pay and damages for emotional distress received to satisfy a claim under Title VII of the Civil Rights Act of 1964. (9) Attorney fees and costs (including contingent fees) where the underlying recovery is included in gross income. (1) (2) (3) (4) (5) (6) (7) (8) Issue 2 How is the $25,000 treated for purposes of Federal tax income? Synopsis The $25,000 is treated as an adjustment to adjusted gross income with a net zero effect, because $25,000 is a trade or business expense that John Smith had paid upfront for the case. Explanatory Detail IRC Section 162 (a) is the oldest and most important of all deduction provisions. It allows a taxpayer to deduct from gross income all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. There are two criteria have emerged from the many court decisions addressing the issue. The first requirement that must be satisfied in order for an activity to be treated as a trade or business activity is a legitimate profit motive. Dogget v. Burrett, 3 USTC 1090, 12 AFTR 505, 65 F.2d 192 (CAD.C.,1933). The second requirement imposed by the court before an activity qualifies as a trade or business. Grier v. U.S 551 USTC 9184, 46 AFTR, 281 F.2d 603 (CA2,1955). It is an important distinction to note that the $25,000 is not deductible for purpose of Federal tax income. According to IRS Publication 535, to be deductible, a business expense must be both ordinary and necessary. An ordinate expense is one that is common and accepted in your industry. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary. That being said, the $25,000 in expenses are the result of an extraordinary event. Under U.S. GAAP, Accounting Principles Board (APB) 30, extraordinary items are events and transactions that are distinguished by their unusual nature and by the infrequency of
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Collins Accounting Services 9002 Near Lakes City Blvd Ste. 400 Near Lake City, MI 40451 Office: (404) XXXXXXX Email: [e-mail]
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their occurrence. Thus, both of the following criteria should be met to classify an event or transaction as an extraordinary item: a) Unusual nature--the underlying event or transaction should possess a high degree of abnormality and be of a type clearly unrelated to, or only incidentally related to, the ordinary and typical activities of the entity, taking into account the environment in which the entity operates. b) Infrequency of occurrence--the underlying event or transaction should be of a type that would not reasonably be expected to recur in the foreseeable future, taking into account the environment in which the entity operates. Issue 3 What is your determination regarding reducing the taxable amount of income for both (1) and (2) above? Synopsis Take the $300,000 payment as a lump sum. Explanatory Detail The determination regarding reducing the taxable amount of income is that you should ask the payment in form of annuity instead of getting a lump sum payment of $300,000. Normally tax on an annuity will be less than on a lump sum, because of the lower rates on lower income brackets. However, if your income in the top brackets then the tax treatment for the $300,000 would be the same, whether lump sum or annuity. According to IRC section 104(a)(2),if an action has its origin in a physical injury or physical sickness, then all damages (other than punitive) that flow therefrom are treated as payments received on account of physical injury or physical sickness whether or not the recipient of the damages is the injured party. In short, any monies received from a personal injury case, except in extremely rare cases, must be reported as ordinary income to the IRS. Issue 4 What are the different tax consequences between paying down the mortgage (debt) and assuming a new mortgage (debt) for Federal income tax purposes? Synopsis Jane Smith only receives a benefit for the amount by which her mortgage interest exceeds her standard deduction for income tax. Explanatory Detail IRC Section 56 includes a different formula for calculating the depreciation deduction, and it eliminates many other deductions completely, including the standard deduction and all personal exemptions. Section 56(b) contains the adjustments applicable to individuals, which the include adjustment for interest in 56(b)(1)(C). Section 56(b)(1)(C) provides that, in determining the amount allowable as a deduction for interest, 163(d), which provides limitations on
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Collins Accounting Services 9002 Near Lakes City Blvd Ste. 400 Near Lake City, MI 40451 Office: (404) XXXXXXX Email: [e-mail]
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investment interest, and 163(h), which disallows deductions for personal interest, shall apply, except that in lieu of the exception under 163(h)(2)(D) for qualified residence interest, the term "personal interest" shall not include any qualified housing interest. IRC Section 56 defines a qualified housing interest 56(e)(1) as interest on any indebtedness resulting from the refinancing of indebtedness meeting the requirements of qualified housing interest, but only to the extent that the amount of the indebtedness resulting from such refinancing does not exceed the amount of the refinanced indebtedness immediately before the refinancing. In short, if you refinance your home, you cannot typically claim the entire amount of the refinance as a deduction even if you take on more debt. Issue 5 Can John and Jane Smith utilize a 1031 tax exchange to buy a more expensive house using additional money from John's case? Synopsis Yes, you can utilize a 1031 tax exchange to buy a more expensive house using additional money from John's case. Explanatory Detail IRC Section 1001 states that in general, whenever an asset is sold or otherwise disposed of, gain or loss from the sale or disposition must be recognized by the taxpayer. However, IRC Section 1031 provides an exception to this rule. Under that section, a taxpayer who exchanges property for other property of "like kind" can defer recognition of any gain or loss until the newly acquired property is sold. The three requirements for a Section 1031 exchange are: 1. Any property exchanged must be held for "productive use in trade or business or for investment." 2. The transaction must qualify as an exchange a swap of property for other property. 3. The properties exchanged must be of "like kind." Issue 6 Does Jane have a business or hobby? Why is this distinction important? Synopsis Jane has a business based on the material participation. Explanatory Detail
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Collins Accounting Services 9002 Near Lakes City Blvd Ste. 400 Near Lake City, MI 40451 Office: (404) XXXXXXX Email: [e-mail]
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Based on Temp. Reg. 1.4695T(a) Jane will be treated as material participating in an activity because of qualifying test 7th required " the individual participates in the activity on a regular, continuous, and substantial basis during the tax year". Code Sec.469 (h) (1). The crucial distinction between a business and a hobby is important because an individual need to know whether the income is passive or active. If profit motive is absent, the deduction is governed by Code Sec.183 as an activity not engage in for profit (i.e. a hobby). Under Code Sec.183, special rules limit the deduction for hobby expenses to the amount of hobby income and no net loss can be deducted for hobby activities. Whereas IRC provides the authority for the deduction of most expenses for trade or business. Code Sec.162 governs the deductibility of trade or business expense and Code Sec.212 govern the tax treatment of expenses incurred "for the production of income." Issue 7 Would Jane (and John) realize better tax benefits if she had a separate business for her jewelry making activities? Synopsis Yes. They realize better tax benefits if she had a separate business for her jewelry making activities. Explanatory Detail IRC Section 162 (a) is the oldest and most important of all deduction provisions. It allows a taxpayer to deduct from gross income all "ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business," including: 1. Reasonable compensation paid out for personal services actually rendered to the business 2. Reasonable travel expenses while away from home in pursuit of the trade or business; and 3. Lease or rental payments necessary to carry out the trade or business, provided the owner of the business has neither title nor equity in the premises in which the trade or business is conducted. Issue 8 What tax benefits would John realize if he invested $15,000 in Jane's jewelry making? Synopsis John would realize tax benefits of business and investment expenses. Explanatory Detail There is a tax deduction for depreciation of the cost of tangible property, specifically personal property (jewelry making equipment). The cost of capital expenditure will be allocated over the periods that will benefit from the expenditure. If you file separate returns, expenses incurred to earn or produce:
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Collins Accounting Services 9002 Near Lakes City Blvd Ste. 400 Near Lake City, MI 40451 Office: (404) XXXXXXX Email: [e-mail]
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1. Community business or investment income are generally divided equally between you and your spouse. Each of you is entitled to deduct onehalf of the expenses on your separate returns 2. Separate business or investment income is deductible by the spouse who earns the income. Issue 9 Can Jane depreciate her vehicle or jewelry making equipment? How? Synopsis Jane can depreciate her vehicle and jewelry making equipment. Explanatory Detail Modified Accelerated cost Recovery System (MACRS) specifies three depreciation methods under GDS and one depreciation method under ADS: 1. 200% declining balance applies to 3year, 5year, 7year and 10year classes of property. 2. 150% declining balance applies to 15year and 20year classes of property. 3. Straightline is used for 27.5year and 39year classes of property. 4. Straightline method over an ADS recovery period. Specially, the extension of "Section 179" of the tax code allows to writeoff the full amount of qualifying equipment or computer software made in 2010 or 2011 up to $500,000 per business per year. Furthermore, there is a bonus depreciation Reintroduced by the Tax Relief, Unemployment Reauthorization and Job Creation Act of 2010. Bonus depreciation for 2011 and 2012 is 100% and 50% respectively. Issue 10 Should John and Jane file separate or joint tax returns? Synopsis Yes, married filing jointly is the most advantageous tax status. Explanatory Detail John and Jane should file a joint tax return. Because married filing jointly provides more tax benefits than filing a separate return. The IRS provides that "If you and your spouse decide to file a joint return, your tax may be lower than your combined tax for the other filing statuses. Also, your standard deduction (if you do not itemize deductions) may be higher, and you may qualify for tax benefits that do not apply to other filing statuses" (from Publication 501, Married filing jointly). Married filing jointly has the most tax benefits, especially when the spouses have different income levels.
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Collins Accounting Services 9002 Near Lakes City Blvd Ste. 400 Near Lake City, MI 40451 Office: (404) XXXXXXX Email: [e-mail]
THE POWER TO PRODUCE EFFECT OR INTENDED RESULT
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Collins Accounting Services 9002 Near Lakes City Blvd Ste. 400 Near Lake City, MI 40451 Office: (404) XXXXXXX Email: [e-mail]