L25: Corporate Taxes ECON 320 Engineering Economics Mahmut Ali GOKCE Industrial Systems Engineering Computer Sciences

Taxable Income and Income Taxes Gross Income Expenses Cost of goods sold (revenues) Depreciation Operating expenses Taxable income Income taxes Net income Item

U.S. Corporate Tax Rate (2005) Taxable income 0-$50,000 $50,001-$75,000 $75,001-$100,000 $100,001-$335,000 $335,001-$10,000,000 $10,000,001-$15,000,000 $15,000,001-$18,333,333 $18,333,334 and Up Tax rate 15% 25% 34% 39% 34% 35% 38% 35% Tax computation $ (  $7, (  $13, (  $22,  $113,  $3,400,  $5,150,  $6,416,  (  denotes the taxable income in excess of the lower bound of each tax bracket

Marginal and Effective (Average) Tax Rate for a Taxable Income of $16,000,000 Taxable incomeMarginal Tax Rate Amount of Taxes Cumulative Taxes First $50,00015%$7,500 Next $25,00025%6,25013,750 Next $25,00034%8,50022,250 Next $235,00039%91,650113,900 Next $9,665,00034%3,286,1003,400,000 Next $5,000,00035%1,750,0005,150,000 Remaining $1,000,000 38%380,000$5,530,000

Example Corporate Income Taxes Facts: Capital expenditure$100,000 (allowed depreciation) $58,000 Gross Sales revenue $1,250,000 Expenses: Cost of goods sold$840,000 Depreciation $58,000 Leasing warehouse $20,000 Question: Taxable income?

Taxable income: Gross income$1,250,000 - Expenses: (cost of goods sold) $840,000 (depreciation) $58,000 (leasing expense) $20,000 Taxable income $332,000 Income taxes: First 15% $7,500 25% $6,250 34% $8,500 39% $90,480 Total taxes $112,730

Average tax rate: Total taxes=$112,730 Taxable income =$332,000 Marginal tax rate: Tax rate that is applied to the last dollar earned 39%

Disposal of Depreciable Asset If a MACRS(Modified Accelerated Cost Recovery System) asset is disposed of during the recovery period, Personal property: the half-year convention is applied to depreciation amount for the year of disposal. Real property: the mid-month convention is applied to the month of disposal.

Disposal of a MACRS Property and Its Effect on Depreciation Allowances

Depreciation recapture Gains = Salvage value – book value = (Salvage value - cost basis) Capital gains + (Cost basis – book value) Ordinary gains Depreciation recapture is taxed as ordinary income. } IF ASSET SOLD FOR MORE THAN THE COST BASIS

Capital Gains and Ordinary Gains Cost basis Book valueSalvage value Capital gains Ordinary gains or depreciation recapture Total gains

Gains or Losses on Depreciable Asset Example 8.11: A Drill press: $230,000 Project year: 3 years MACRS:7-year property class Salvage value:$150,000 at the end of Year Full Half Total Dep. = 230,000( /2) = $109,308 Book Value = 230, ,308 = $120,693 Gains = Salvage Value - Book Value = $150,000 - $120,693 = $29,308 Gains Tax (34%) = 0.34 ($29,308) = $9,965 Net Proceeds from sale = $150,000 - $9,965 = $140,035

Calculation of Gains or Losses on MACRS Property

Summary The entire cost of replacing a machine cannot be properly charged to any one year’s production; rather, the cost should be spread (or capitalized) over the years in which the machine is in service. The cost charged to operations during a particular year is called depreciation. From an engineering economics point of view, our primary concern is with accounting depreciation; The systematic allocation of an asset’s value over its depreciable life.

Accounting depreciation can be broken into two categories: 1. Book depreciation—the method of depreciation used for financial reports and pricing products; 2. Tax depreciation—the method of depreciation used for calculating taxable income and income taxes; it is governed by tax legislation. The four components of information required to calculate depreciation are: (a) cost basis, (b) salvage value, (c) depreciable life, and (4) depreciation method.

Because it employs accelerated methods of depreciation and shorter-than-actual depreciable lives, the MACRS (Modified Accelerated Cost Recovery System) gives taxpayers a break: It allows them to take earlier and faster advantage of the tax-deferring benefits of depreciation. The total amount of taxes to pay remains unchanged regardless of depreciation methods adopted. It only changes the timing of the payment. Many firms select straight-line depreciation for book depreciation because of its relative ease of calculation.

Given the frequently changing nature of depreciation and tax law, we must use whatever percentages, depreciable lives, and salvage values mandated at the time an asset is acquired.

Component of Depreciation Book DepreciationTax depreciation (MACRS) Cost basisBased on the actual cost of the asset, plus all incidental costs such as freight, site preparation, installation, etc. Same as for book depreciation Salvage valueEstimated at the outset of depreciation analysis. If the final book value does not equal the estimated salvage value, we may need to make adjustments in our depreciation calculations. Salvage value is zero for all depreciable assets

Component of Depreciation Book DepreciationTax depreciation (MACRS) Depreciable life Firms may select their own estimated useful lives or follow government guidelines for asset depreciation ranges (ADRs) Eight recovery periods– 3,5,7,10,15,20,27.5,or 39 years– have been established; all depreciable assets fall into one of these eight categories. Method of depreciation Firms may select from the following: Straight-line Accelerated methods (declining balance, double declining balance, and sum-of- years’ digits) Units-of-proportion Exact depreciation percentages are mandated by tax legislation but are based largely on DDB and straight-line methods. The SOYD method is rarely used in the U.S. except for some cost analysis in engineering valuation.

Explicit consideration of taxes is a necessary aspect of any complete economic study of an investment project. Once we understand that depreciation has a significant influence on the income and cash position of a firm, we will be able to appreciate fully the importance of utilizing depreciation as a means to maximize the value both of engineering projects and of the organization as a whole.

For corporations, the U.S. tax system has the following characteristics: 1. Tax rates are progressive: The more you earn, the more you pay. 2. Tax rates increase in stair-step fashion: four brackets for corporations and two additional surtax brackets, giving a total of six brackets. 3. Allowable exemptions and deductions may reduce the overall tax assessment.

Marginal tax rate is the rate applied to the last dollar of income earned; Average (effective) tax rate is the ratio of income tax paid to net income; and Incremental tax rate is the average rate applied to the incremental income generated by a new investment project. Capital gains are currently taxed as ordinary income, and the maximum rate is capped at 35%. Capital losses are deducted from capital gains; net remaining losses may be carried backward and forward for consideration in years other than the current tax year.