The Most Taxing Questions – Taxes and Cash Flows © 2004 Dr. B. C. Paul

Taxes and Project Analysis  Showed you how to get cash flows and compute returns but do you really get the money?  Income taxes of 32% - 36%  Sales taxes of 7%  Property taxes of several percent of asset values  An Average American usually works a little over 4 months/year just to pay taxes  We often talk of “Before” and “After” Tax Analysis

Rates of Return  Real and Nominal  Before tax and After tax  And of course combinations Nominal – After Tax Rate of Return  Need to Make Sure You Are Consistent

Doing A Cash Flow With Taxes  Cash flows for Engineering Economic Analysis are simply lists of money received and money spent on a time line showing when the event occurs  Adding Taxes to Your Cash Flow  Taxes are an expense – put them on the time-line where they occur  Implicit in putting Tax on the time line is that you know what the amount is

Several Types of Taxes  Sales Taxes  Charged to End User of Product  Normally not charged on raw material inputs to a process  If make aluminum out of bauxite, bauxite is normally not taxed  Tax occurs whether or not business or individual is making a “profit”  Ie they can make your initial negative cash flows larger, not just your later positive flows smaller

Types of Taxes  Property Taxes  Levied on value of assets (saw some examples with Herby and Hanna Housing)  Also levied whether or not business has a profit  Inventory Taxes  Normally target retailers to get them to move goods not just sit on them  Again levied whether or not business has a profit

Income Tax  Normally the single largest bite  Bush has tried to cut rate but can still be 36%  Historically and in some places income tax can be 90%  Extent to Which a Business pays income taxes varies with how business is set up

Common Business Arrangements (Liability and Tax Issues)  Sole Proprietorship  This is your own business (sometimes a jointly owned business with a spouse)  Husband-Wife teams may become one entity for tax purposes  Business is handled as part of your personal tax return  Generally use a series of schedules with a 1040 long form  Profits and losses become part of your personal income

The Sole Proprietorship  Liability Issues  The actions and liabilities of the business are your actions and liabilities  In Civil action your personal assets may be seized to satisfy business problems  Risk issues  You must capitalize the business and assume all the risk

The Partnership  Risk Mitigation  The capitalization and skills aspects of the business are split between multiple individuals  For Tax Purposes the earnings and losses of the business split to each individuals taxes - just like a sole proprietorship only earnings or losses are ratios of ownership

The Partnership Peril  Partnership is seldom used today  Liability problem  The actions of any partner or the business become your actions  Including the personal debts and actions of your partner

The Corporation  Incorporation causes the business to become a separate entity - legally and for tax purposes  You have no liability for the actions and finances of the business (unless there was knowing illegal action - pierce the corporate veil)  Board of Directors generally are not liable and company often buys insurance for them

Incorporating  Incorporating is relatively inexpensive  About $50 to file  There is a lot of paperwork both to create and maintain  Have to decide where to incorporate - Incorporation is a State legal action  have to have some sort of business presence in your state of incorporation

Taxing Corporations  A corporation fills out its own tax returns and pays its own taxes  Only distributions of earnings are a taxable event for individual owners of corporations  Sale of your interest in a corporation will usually create a “Capital Gains” event.

Decisions in Corporate Structure  Should Project be set up as stand alone proposition or a subsidiary of larger company  Tax Loss Problem  Most projects cause negative initial cash flows and losses  Can only write off tax losses to the extent of the profit  Independent companies must carry tax loss forward (ie if they come out with a loss you move it forward as a deduction next year)  You don’t pay taxes that year but there is no check back from the government  At 15% next year the deduction is only worth 85 cents on the dollar  Limited to 7 years carry forward or 3 years carry back

Impact of Carry Forward  Tax reductions expand bottom line cash flow  Carry forward delays a positive revenue event – hurts NPV  Carry forward can also make company a take over target  If company has $30 worth of tax deductions carrying forward for every $100 of value – you are for sale for 70 cents on the dollar to a large corporation

Corporate Subsidiary Option  Tax books and filings are on the parent company  Company can use initial investments and negative cash flows as a deduction against income  Moves tax benefits forward in time and sweetens the NPV  Liability Problem  If something goes wrong in the subsidiary company the parent company is liable  Phillip Morris and Cigarette Dilema

Investor Returns and Corporate Buisiness  The Double Tax Problem  The company pays tax on its profits  Have different tax rates than individuals (often less favorable)  Companies after tax profits go to share holders who then pay tax on the income as part of their income tax  Money to the investor gets double dipped by Uncle Sammy

Fighting Double Taxation  Individuals who incorporate their freelance work use Corporation for protection  Paper work transfers earnings to individual as wages or bonuses so corporation makes little or no money  Subchapter S Corporations / Trusts  Corporations distribute their tax events directly to the share-holders  Share holders deal with on their own income tax

S Type Corporations  Attempt to give people what use to be possible with partnerships  Paper-work is rather restrictive  Can make for nightmarish individual tax returns  There are limits on what S Type can do  Corporate Veil may not be quite as effective