Corporate Taxes Lecture No.25 Professor C. S. Park Fundamentals of Engineering Economics Copyright © 2005.

Corporate Taxes

Lecture No.25Professor C. S. ParkFundamentals of Engineering EconomicsCopyright © 2005

Taxable Income and Income Taxes

Gross IncomeExpenses Cost of goods sold (revenues) Depreciation Operating expensesTaxable incomeIncome taxes

Net income

Item

U.S. Corporate Tax Rate (2005)

Taxable income0-$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 rate15%25%34%39%34%35%38%35%

Tax computation$0 + 0.15($7,500 + 0.25 ($13,750 + 0.34($22,250 + 0.39$113,900 + 0.34$3,400,000 + 0.35$5,150,000 + 0.38$6,416,666 + 0.35

(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 income Marginal Tax Rate

Amount of Taxes

Cumulative Taxes

First $50,000 15% $7,500 $7,500

Next $25,000 25% 6,250 13,750

Next $25,000 34% 8,500 22,250

Next $235,000 39% 91,650 113,900

Next $9,665,000 34% 3,286,100 3,400,000

Next $5,000,000 35% 1,750,000 5,150,000

Remaining $1,000,000

38% 380,000 $5,530,000

Average tax rate =$5,530,000

$16, ,.

000 00034 56%

Example 8.10 - Corporate Income Taxes

Facts:Capital expenditure $100,000(allowed depreciation) $58,000

Gross Sales revenue $1,250,000

Expenses:Cost of goods sold $840,000Depreciation $58,000Leasing 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 $50,000 @ 15% $7,500

$25,000 @ 25% $6,250$25,000 @ 34% $8,500$232,000 @ 39% $90,480

Total taxes $112,730

• Average tax rate:

Total taxes = $112,730Taxable income = $332,000

• Marginal tax rate:Tax rate that is applied to the last dollar earned

39%

Average tax rate =$112,730

$332,000

33 95%.

Disposal of Depreciable Asset• If a MACRS 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.

Capital Gains and Ordinary Gains

Cost basis Book value Salvage value

Capital gains

Ordinary gainsor

depreciation recapture

Total gains

Gains or Losses on Depreciable Asset

Example 8.11: A Drill press: $230,000Project year: 3 yearsMACRS: 7-year property classSalvage value: $150,000 at the end of Year 3

14.29 24.49 17.49 12.49 8.92 8.92 8.92

Full Full Half

Total Dep. = 230,000(0.1439 + 0.2449 + 0.1749/2) = $109,308Book Value = 230,000 -109,308 = $120,693Gains = Salvage Value - Book Value = $150,000 - $120,693

= $29,308Gains Tax (34%) = 0.34 ($29,308) = $9,965Net 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 Depreciation Tax depreciation (MACRS)

Cost basis Based on the actual cost of the asset, plus all incidental costs such as freight, site preparation, installation, etc.

Same as for book depreciation

Salvage value Estimated 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 Depreciation Tax 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-lineAccelerated 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.