Depreciation Conclusion

Taxable Income + Gross Income - Depreciation Allowance - Interest on Borrowed Money - Other Tax Exemptions = Taxable Income

Corporate Tax Rate

Corporate Tax Ex: Suppose K-Corp earns $5,000,000 in revenue above manufacturing and operations cost. Suppose further that depreciation costs total $800,000 and interest paid on short and long term debt totals $1,500,000. Compute the tax paid.

Corporate Tax Gross Income$ 5,000,000 Depreciation- 800,000 Interest - 1,500,000 Taxable Income$ 2,700,000

Corporate Tax Gross Income$ 5,000,000 Depreciation- 800,000 Interest - 1,500,000 Taxable Income$ 2,700,000 Tax= $ 113, (2,700, ,000) = $ 918,000

Methods of Depreciation u Straight Line (SL) u Declining Balance (DB) u Prior to 1981 u Modified Accelerated Cost Recovery (MACRS) u Depletion u Sum-of-Years Digits (SYD)

Time Value of Tax Savings (Tax Rate = 40%)

9 MACRSMACRS Prior to 1981, taxpayers could choose among several methods when depreciating assets for tax purposes. With the Economic Recovery Act of 1981, ACRS was required and MACRS was instituted in MACRS is a simpler, more rapid depreciation method.

MACRS Tables

Modified Accelerated Cost Property Classes 3 yr. - useful life < 4 yrs. autos, tools 5 yr. - 4 yrs. < useful life < 10 yrs. office epuipment, computers, machinery 7 yr < UL < 16 office furniture, fixtures, exploration 10 yr < UL < 20 vessels, tugs, elevators (grain) 15 yr < UL < 25 data communication, sewers, bridges, fencing

MACRS (Cont.) 20 yr. - UL > 25 farm buildings, electric generation residential rental property non-residential real property Depreciation class (3, 5, 7, 10 yr.) uses 200% declining balance switching to optimal year class (15, 20) 150% DB switch to SLD class (27.5, 31.5) use straight-line

Class Problem A company plans to invest in a water purification system (5 year property) requiring $800,000 capital. The system will last 7 years with a salvage of $100,000. The before-tax cash flow for each of years 1 to 6 is $200,000. Regular MACRS depreciation is used; the applicable tax rate is 34%. Construct a table showing each of the following for each of the 7 years.

Solution

Depletion Method u Allows for equal depreciation for each unit of output where V t = volume extracted during the year V = total volume available in reserve (I-S) = depreciable amount allowed V V SID t t )( 

Example Ex: NorCo Oil has a 10 year, $27,000,000 lease on a natural gas reservoir in western South Dakota. The reservoir is expected to produce 10 million cubic ft. of gas each year during the period of the lease. Compute the expected depletion allowance for each year.

Example Ex:

Percentage Depletion u Depletion is taken as a constant percentage of gross income Allowable Percentages Oil/Gas15% Natural Gas22% Sulphur/Uranium22% Gold, silver, …15% Coal10%

Example Ex: NorCo Oil has a 10 year, $27,000,000 lease on a natural gas reservoir in western South Dakota. The reservoir is expected to produce 10 million cubic ft. of gas each year during the period of the lease at $1.50 per cubic ft. Gross Income = 1.5(10,000,000) = 15,000,000 Depletion= 15,000,000 (0.22) = $3,300,000

22 Sum of Years Digits Method SOYD = … + N = N(N+1) 2 D n = ( N – n + 1 ) ( I – S ) SOYD B n = B n–1 – D n

Depreciation Recapture Ex: K-Corp purchases a Loader for $250,000 which has a 7 year property class life. After 3 years, $140,675 has been depreciated and the book value is now $109,325. K-Corp now sells the loader for $150,000.

Depreciation Recapture Ex: K-Corp purchases a Loader for $250,000 which has a 7 year property class life. After 3 years, $140,675 has been depreciated and the book value is now $109,325. K-Corp now sells the loader for $150,000. Recapture = 150, ,325 = $40,675

Depreciation Recapture Ex: K-Corp purchases a Loader for $250,000 which has a 7 year property class life. After 3 years, $140,675 has been depreciated and the book value is now $109,325. K-Corp now sells the loader for $150,000. Recapture = 150, ,325 = $40,675 $40,675 taxed as ordinary income

Depreciation Recapture Ex: Suppose K-Corp were able to sell this same loader for $ 275,000. Capital Gain = 275, ,000 = $25,000 Depr. Recapture = 250, ,325 = $140,675

Depreciation Recapture Ex: Suppose K-Corp were able to sell this same loader for $ 275,000. Capital Gain = 275, ,000 = $25,000 Depr. Recapture = 250, ,325 = $140,675 $ 25,000 taxed at 28% $140,675 taxed at 35%