You Decide – John and Jane Smith
Dear John and Jane Smith,
Presented within this memo, you will find answers to your questions brought up during our meeting. Please take a look and let me know what you decide based on the facts below.
John, congratulations on winning your case, now regarding the money you received as part of the settlement; as you said was in the amount of $300,000 and it represented your legal fees. As such this would be treated as ordinary self employment earnings in other words taxable income. Justifiably, since the amount is substantial you are considering some other options. To help minimize the impact you can put some of it away into a Self Employed 401K. Since the money is considered earned, you are able to put some of it away for your retirement. This plan allows for a “greater retirement contribution which in turn can mean increased tax deductions and lower taxable income.”1 However, for such a large amount of earnings this will only represent a small portion, but every little counts.
On the other hand the $25,000 you put up front for your client can help offset your taxable income. This money is deductible as a business expense and would help offset your business income. Keep in mind that if you already took the deduction when the expense was put up two years ago, then you cannot take it again. If this is the case the $25,000 would also be taxable income.
You have a registered LLC, but you may have the option to choose to report these amounts using your personal tax return on Form 1040 schedule C or file separately using form 1065, schedule K-1. However if the business is incorporated you would need to use form 1120 and a separate set of rules apply to corporations.
The $3,500 lease you currently pay for the office space is also treated and reported as a business expense. As you are considering buying the entire building, you would benefit from owning and may even look to rent out additional office space and having rental income. Purchasing the building can turn out to be a good investment if the price is right and if the return on your investment is worth it, you will benefit from it in the long run. The building will become a capital asset for your business and even if the building is paid off (with the money you received from the settlement) you can still take a deduction for depreciation and any building improvements that are done, property taxes and even insurance coverage for the building qualifies2.
Moving on to Jane’s questions, the excess fund from John’s case can definitely be used for other purposes. Thinking of buying a new home can be a good option. However a few things to consider are whether you would realize a gain from the sale of your current home and how it gets reported. If you pay off your current mortgage first, when the property is sold, you would have incurred a larger gain, than if you sold the house and bough another one after