John Smith Tax Issues

1. John Smith tax issues:

a. How is the $300,000 treated for purposes of Federal tax income?

The full amount, $300,000.00, is included in gross income since it was money earned from a service provided. In 1913, the Sixteenth Amendment to the U.S. Constitution was ratified. It empowered Congress to tax "incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration." The Internal Revenue Code is today embodied as Title 26 of the United States Code (26 U.S.C.) and is a lineal descendant of the income tax act passed in 1913, following ratification of the Sixteenth Amendment (Income tax, 2011).

b. How is the $25,000 treated for purposes of Federal tax income?

The $25,000 is also included in gross income for the current year. If the expenses were deducted in the previous years for tax purposes, any reimbursements received after are considered income which will, overall, zero out expenses.

c. What is your determination regarding reducing the taxable amount of income for both (a) and (b) above?

To get the best tax reductions based on the income earned, it would be best to receive annuities (if the option is available) rather than a lump sum. When income is received as an annuity under an annuity, endowment, or life insurance contract, the amount received generally consists of two separate parts: (1) a nontaxable return of the annuitant's investment in the contract and (2) a taxable amount representing a gain on the investment (interest). Code Sec. 72(a).

Under special rules for the taxation of amounts received as an annuity and paid out for reasons other than the death of the insured, the tax-free portion of annuity income is spread evenly over the annuitant's lifetime (Englebrecht & , 2011).

If the option for an annuity is not available, then you would be better off reducing taxable income through retirement accounts such as an SEP IRA. The 2012 SEP IRA contribution limit is $50,000 (2011 limit is $49,000). Contributions to a SEP IRA are generally 100% tax deductible and investment earnings in a SEP IRA grow taxed deferred (Beacon Capital Management Advisors, 2012).

In order to ensure the best tax savings, we need to classify the LLC to act like an S-Corp by filing Form 8832 if you have not yet elected to. An eligible entity makes its election to change its default classification by filing Form 8832 (Entity Classification Election). The entity also indicates the effective date of the election (Englebrecht & , 2011).

This will reduce the amount of self-employment tax on the salary amount and base it on the market rate salary instead of total Adjusted Gross Income.

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