1. 1/12 MER 439 - Design of Thermal Fluid Systems Engineering Economics B asics of Taxation Professor Anderson Spring Term 2012

2. 2/12 Basics of Taxation For Corporations  Corporations pay taxes on income generated while doing business  When performing an economic analysis one must determine if it is a before or after tax analysis  For tax-exempt organizations it is not necessary  Most analysts do after tax analyses

3. 3/12 Definitions Gross Income - (GI) Total of all income from revenue producing sources Expenses - (E) All costs incurred while transacting business Taxable Income - (TI) The dollar value remaining upon which taxes are to be paid. TI = Gross Income – Expenses – Depreciation

4. 4/12 Definitions Continued Capital Gain: Gain incurred when the selling price an asset or real property exceed the purchase price (unadjusted basis) Capital Gain = Selling Price – Unadjusted Basis STG= Short Term Gain < 1 y or 6 months LTG= Long Term Gain > 1 yr or 6 months

5. 5/12 Definitions Continued Capital Loss: Selling Price is Less than BV Capital Loss = BV- Selling Price Short term (STL), Long Term (LTL) Recaptured Depreciation: RD = Selling Price – BV > 0

6. 6/12 Basic Tax Formulas and Computations Taxes = (GI – E – D)*T = TI*T T = Tax Rate Corporate Federal Income Tax Rate Schedule Taxable IncomeTax RateCorporate Income Tax < $50,000 15%15% over 0 $50,000-75,000 25%$7,500 + 25% over $50,000 $75,000-100,000 34%$13,750+34% over $75,000 $100,000-335,000 39%$22,250+39% over $100k $335,000-10 mil 34%$113,900+34% over $335k $10 mil-15 mil 35%$3.4 mil+35% over $10 mil >$15 mil 38%$5.159 mil+38% over $15 mil

7. 7/12 Example A company has a GI = $2,750,000 with expenses and depreciation = $1,950,000. Compute the federal tax. TI = $2,750,000-1,950,000 = $800,000 Taxes = 113900 + 0.34*(800,000-335,000) Taxes = $272,000 Average Tax Rate=Total taxes paid/TI =$272,000/$800,000 =0.34

8. 8/12 Effective Tax Rate Accounts for all taxes (federal and state) T e = state rate + (1-state rate)(federal rate) That is, T e = state rate + federal rate - (state rate)(federal rate) Taxes=TI x T e

9. 9/12 Cash Flow Terms CFBT: Cash Flow Before Taxes CFAT: Cash Flow After Taxes CFBT=Gross Income - Expenses TI = CFBT – Depreciation Taxes = TI*T CFAT = CFBT - Taxes

10. 10/12 The Effect of Depreciation on Taxes  The amount of taxes incurred is affected by the depreciation model chosen  Accelerated methods require less taxes in the early years  Assumptions: Constant tax rate Gross Income exceeds Annual Depreciation Capital recovery down to same SV Same number of years  Then Total taxes paid are equal for any depreciation models The PW of taxes, P tax, are less for accelerated depreciation models

11. 11/12 Example Construct the CF diagram for taxes and calculate the PW of taxes for a $9000, 5 year recovery asset if the effective tax rate is 40%. CFBT is estimated at $10,000 per year and the interest rate is 12% per year, Use the 150% declining balance method of depreciation

12. 12/12 Solution d = 1.5/n = 1.5/5 = 0.3 B = $9000 D t = dB(1-d) t-1 = 0.3(9000)(0.7) t-1 P taxes = $12,094