The Most Taxing Questions – Cash Flows and Tax Books © 2004 revisions 2012 Dr. B. C. Paul

Income Tax  Income Tax is a government take of a businesses (or your) intake of new wealth  To calculate the tax your must determine the income  In simplest terms  Gross Earnings – Business Expenses  But what are business expenses?

Net Income May Not Be So Easy  Business Expenses  Could just tax the cash flow  Problem is that projects produce large negative cash flows during set up  Assets last for years  General feeling that a producing asset that would serve years of production could not be written off in one year  There was also an accounting tradition of writing long lived assets off over time.  Would Make Revenue swing wildly

A Split in Conventions  Taxes and Accountants spread the cost of long lived assets over time  Cash Flows put expenses where they physically occur  Result – Multiple Sets of Books  Cash Flow book is based on when real money moves  Tax and Accounting Books are based on conventions spreading costs for long lived assets over time

The Pain  Your Cash Flow has to show when real money moves  Taxes going out represent real money moving  Therefore you have to keep a set of funny money books to keep track of taxes so you can decide when real money moves

The Fate of Money Spent  Split into Expensed or Depreciated (and a neither category)  An asset that is depreciated  Is used for business purpose to produce income  Have an identifiable useful life of more than 1 year  Must decay, be used up, wear out, or loose value to the owner

Expenses  Expensed items  Have useful life of less than a year  Or have a specific allowance in the tax code for them to be written off  Example – Small businesses can write-off about 20K per year of office equipment even though it satisfies definition of depreciable asset  Examples of Expensed Items  Labor Expenses  Utilities  Office consumables  Raw material inputs to your process

Calculating Taxable Income  Calculating Taxable Income  Gross Receipts  Minus Expenses  Expensed Items are taken off “Income” in the year they occur

Expensing of Interest  Interest Expenses  Borrowed money is partially covered by taxes  Investor returns must all be after tax  Can put substantial advantage into leverage  (corporate tax rate is 34% - interest is only 2/3rds of face amount after taxes)  (Warning it will still lever you down at full face amount if things go rotten)  The Working Capital Impact  Need rotating money for supplies and labor between time of manufacture and time of sale  If take from investor you need full investment rate of return  If you borrow it about 40% of interest will be a direct reduction in taxes  Short term corporate paper – what happens if credit freezes

Examples of Depreciable Items  Manufacturing tools  Handling devices for food and beverage manufacture  Autos and Aircraft  Computers and Office Equipment  Buildings or mine structures  Utility distribution or sewage treatment facilities

What Happens to Depreciable Items  Gross Income  Minus Expenses  Minus the portion of Depreciable item cost allowed each year  Minus other Depreciation like categories  Equals Taxable Income  Multiplied by your tax rate  Equals the Money from your cash flow you give to the government.

Cash Flow Items Neither Expensed or Depreciated  Land (considered to be an asset that retains and holds value – money spent is just converted into a different form)  Savings  Purchase of Stock or bonds or hedging instruments  Individual Personal Home  Rental houses are depreciated  They produce income – personal homes don’t – they are personal consumption

The Neither Category  Anything that simply transforms the form in which you hold your earnings  Land  Purchase of Stock  Money in Savings  Things representing end use consumption  Things spent to support your individual needs are not write-offs

Peculiarities and Short- Circuits  Automobile  If you buy an auto and use it to drive to work to make living – no write-off  If you incorporate and use the vehicle to deliver your corporations services used to make money it is a write-off  Inputs to Manufacturing  Raw materials inputs to product  Illinois State Tax on fertilizers used in agricultural production an out of place example