Recommendations to Mr & Mrs Smith

Dear Mr. & Mrs. Smith,

It was a pleasure meeting with you on last week. This memo contains a list of the concerns that you mentioned during our meeting and the recommendation I have for each of your concerns. Please call me once you have reviewed the memo so we can go over any questions you may have and work on getting things in order.

John's questions:

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

• The $300,000 is included in your gross income. You earned the $300,000 by providing legal services. For federal income tax purposes, "gross income" means all income from whatever source derived and includes compensation for services I.R.C. § 61. Any income, from whatever source, is presumed to be income under section 61, unless the taxpayer can establish that it is specifically exempted or excluded. In Reese v. United States, 24 F.3d 228, 231 (Fed. Cir. 1994), the court stated, "An abiding principle of federal tax law is that, absent an enumerated exception, gross income means all income from whatever source derived".

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

• The 25,000 should be included as part of income for the current year. If the expenses had not been expensed or deducted in the year the expense was incurred then it should be deduction this year. Either way, the net effect should zero out.

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

There are a few tax planning strategies we can implement in order to increase maximize your deductions and reduce your liabilities.

• First of all let us make sure that you have the entity structure that best suits your needs. If your business which is an LLC has not filed the election to be treated as an S corporation I recommend that we do so immediately. Why? As an LLC filing a Schedule C with the 1040 the business is required to pay self-employment tax on the total Adjusted Gross Income; while with the S Corp you may take a market rate salary and have to pay self-employment tax on the salary amount and not the total AGI of the business. I recommend that we file the form 2553 to make an S corporation Election.(Under section 1362 of the Internal Revenue Code)

• Reducing taxable income through retirement contribution. I recommend that you open a SEP IRA. Please note that you also have the option of opening a 401k plan.

• After considering your particular situation I think it is still in your best interest to go with the SEP IRA.

Characteristic of SEP IRA versus 401k Plan

In 2010 and 2011 there is $49,000 maximum contribution ($54,500 if age 50+ due to a "catch-up" provision). Loans are permitted in an Individual 401k In 2010 and 2011 there is $49,000 maximum contribution

Easy to setup and low administrative responsibilities Potentially greater administrative responsibilities and administrative fees compared to a SEP IRA

An Individual 401k may provide a larger contribution and tax deduction compared to a SEP IRA. For those age 50+ there isn't an additional $5500 catch-up contribution provision like there is with the Individual 401k Potentially greater administrative responsibilities and administrative fees compared to a SEP IRA

Note that if you have a combination of both w2 income and self-employment income, each plan is independent of the other. You may contribute to both the 401k and SEP IRA

2. Jane's questions:

a. What are the different tax consequences between paying down the mortgage (debt) and assuming a new mortgage (debt) for Federal income tax purposes?

• For tax purposes we are allowed to deduct only the mortgage interest. So the only difference for tax purposes would be the amount of interest that can be deducted.

b. Can John and Jane Smith utilize a 1031 tax exchange to buy a more expensive house using additional money from John's case?

No. The 1031tax exchange can't be used because 1031 exchange applies to investment and business property.

§ 1031. EXCHANGE OF PROPERTY HELD FOR PRODUCTIVE USE OR INVESTMENT.

c. Does Jane have a business or hobby? Why is this distinction important?

Jane