Memo
To: John and Jane Smith
From:
Date: 8/17/14
Re: Memo summarizing various tax issues
1. John Smith's Tax Issues
Issue (a): How is the $300,000 treated for purposes of federal tax income?
Applicable Law and Analysis
As the $300,000 you received this year from the jury award is considered compensation, it has to be included as part of your gross income per Code Sec 61(a)(1), which states that gross income is “all income from whatever source derived, including (but not limited to) the following items: compensation for services, including fees, commissions, fringe benefits and similar items.” (www.irs.gov/pub/irs-drop/rr-07-19.pdf), Additionally, IRC section 451(a) states “the amount of any item of gross income shall be included for the taxable year in which received by the taxpayer, unless under the method of accounting use in computing taxable income, such amount is to be properly accounted for as of a different period.” (www.irs.gov/irb/2011-05_IRB/ar08.html#d0e1606)
Conclusion
When you prepare your taxes according to IRC section 451(a), you must include the $300,000 in compensation as part of your gross taxable income. Because there was no way to know the compensation amount prior to the judgment, you could not have used the accrual method of accounting for the previous years in which you worked on this case.
Issue (b): How is the $25,000 treated for purposes of federal tax income?
Applicable Law and Analysis
Code Sec 162(a) “allows a deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” (http://www.irs.gov/pub/irs-drop/rr-99-7.pdf) Allowed expense deductions include compensation for any services actually rendered, travel expenses, and rental or other payments for the business.
Per Code Sec 61(a)(1) from above, the $25,000 would be considered gross income as part of compensation for services. However, it may also be considered a deduction for your adjusted gross income as a business expense per Code Sec 162(a). Without knowing exactly what the expenses associated with the $25,000 were, I can only assume they would meet the criteria for deductions under Code Sec 162(a).
Conclusion
If the expenses against the $25,000 are allowed under Code Sec 162(a), it is required that the expenses which occur during the taxable year and the expenses against the $25,000 are over a two year period, they must be allocated against each tax year. Expenses that were incurred in the first year of the case should have been deducted against that year’s gross income, and the remainder of expenses as they apply to the $25,000 should be deducted against this year’s gross income. By doing this, the $25,000 in income is offset by the $25,000 spent on expenses in the current year.
Issue (c): What is your determination regarding reducing the taxable amount of income for both (a) and (b) above?
Applicable Law and Analysis
For the expenses, per Code Sec 162(a), this allows for reasonable allowances for salaries and other forms of compensation, traveling expenses when away from the home office, and any rental payments necessary to conduct business (provided the taxpayer has no title claim or equity in the property). Additionally, we must identify all of the ordinary and necessary expenses paid or incurred in the current tax year related to you conducting your business, and will apply Code Sec 162(a).
Conclusion
Both the $300,000 and the $25,000 need to be included in this year’s taxes as gross income, but you can also deduct the current year’s expenses from your income tax. One option is to amend last year’s tax return and use the accrual method of accounting, splitting the income and expenses over two years, and therefore reducing this year’s taxable income.
Issue (d): Do I get better tax benefits for paying the lease on office space or for buying the building? What are the differences?
