John Smith Attorney - Federal Tax Income Case Study

1(a)

John Smith, a practicing attorney at law with established LLC, received cash lump sum of $300,000 as his fee for over two years of work on a large jury case which he won for his client. How is the $300,000 treated for purposes of Federal tax income?

According to IRC Publication 3402 Taxation of Limited Liability Companies: An individual owner of a single-member LLC classified as a disregarded entity is not an employee of the LLC. Instead, the owner is subject to tax on the net earnings from self-employment of the LLC which is treated in the same manner as a sole-proprietorship (http://www.irs.gov/publications/p3402/ar02.html#en_US_publink1000205890).

With IRC Publication 3402 in mind, the $300,000 of active income would be treated as self-employment active income subject to the self-employment taxation in the year when it was constructively received. Since this LLC is being treated as cash basis accounting sole proprietor, the compensation is taxed when received.

1(b)

John Smith was paid $25,000 for recovery of expenses paid up front. How is the $25,000 treated for purposes of federal tax income?

Both IRS Code section 162 and 212 govern and determine if business expenditures satisfy the deductibility criteria. Code Sec. 162 says, for an expenditure to qualify as a deductible, it must be related to carrying on a trade or business activity with profit motives and significant taxpayer’s involvement; it must be ordinary and necessary; it must be reasonable; and it must be paid during the taxable year (http://www.law.cornell.edu/uscode/html/uscode26/usc_sec_26_00000162----000-notes.html).

The $25,000 expense recovery payment is reported as self-employment income constructively received. The expenses associated with this expense recovery payment, will be ordinary business deductions, expensed as they were incurred throughout the court case during the previous two years, per the cash-basis accounting method. This is a payment in arrears for the expenses incurred over the past two years directly related to the court case at hand. This payment will be subject to self-employment income taxes.

1 (c)

What is the determination regarding reducing the taxable amount of income for both the $300,000 fee income and $25,000 expense re-imbursement income?

According to IRC Section 469(i), an individual may deduct annually up to $25,000 of passive activity losses (to the extent they exceed passive activity income) that are attributable to rental real estate activities in which the taxpayer actively participates (http://www.lyster.com/tax/469.htm).

When comparing, if to buy the office building John Smith currently leases from, this would not reduce his taxable income because it would effectively eliminate the lease

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