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Depreciation & Taxes

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Given an initial Price, class life, and end of useful life salvage value, be able to compute a depreciation schedule for straight line depreciation decline balance method (100% < p < 200%) declining balance with automatic conversion to straight line declining balance with conversion to straight line using the half-year convention MACRS depreciation Be able to compute a depletion schedule using adjusted cost basis. Given an estimated Net Income, be able to compute a corporate income tax. Given a before tax cash flow, be able to compute an after tax cash flow.

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U.S. income tax rates have changed significantly over the past 100 years. Shown below are the top marginal income tax rates for individuals and corporations. Source: www.taxpolicycenter.org for top individual tax rates and top corporate rates.

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Performing Income Tax Calculations Can Be Challenging Congress Has Simplified Income Tax Calculations for 2012

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A small business is forecasting a taxable income of $50,000 for the year. The owner is considering making an investment that will increase taxable income by $45,000. If the investment is pursued and the anticipated return occurs, what will be the magnitude of the increase in income taxes caused by the new investment? What would be the magnitude of the increase in income taxes if the company forecasts a taxable income of $400,000 for the year?

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With a “base” taxable income of $50,000, the federal income tax will be 0.15($50,000), or $7500. The income tax for a taxable income of $95,000 will be $13,750 + 0.34($20,000) = $20,550. With a “base” taxable income of $400,000, the federal income tax will be $113,900 + 0.34($65,000) = $136,000 or 34% of $400,000. Because every dollar of the additional $45,000 in taxable income will be taxed at 34%, the increase in taxable income will be 0.34($45,000) = $15,300 for a total tax of $151,300.

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effective tax rate = income tax divided by taxable income; incremental tax rate = average rate charged to incremental taxable income; and marginal tax rate = tax rate that applies to the last dollar included in taxable income.

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For Example 10.1, the effective tax rate, when “base” taxable income is $50,000 and an additional $45,000 in taxable income will occur, is $20,550/($50,000 + $45,000), or 21.63%. The incremental tax rate is ($20,550 - $7500)/$45,000, or 29%. The marginal tax rate is 34%.

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Company Effective Tax Rate Company Effective Tax Rate ABB27%Federal Express38% Abbott Laboratories19%Hewlett-Packard20% Coca-Cola16%Home Depot37% ConocoPhillips42% Pepsi23% Eli Lilly 22%Wal-Mart32%

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Sole Proprietor S-Corp Taxable Income$50,000Taxable Income$50,000 Salary @ 40% of Taxable Income $20,000 Self-Employment Tax @ 15.3% $7,650Social Security and Medicare Tax @ 15.3% $3060 Savings = $4590* *less corporate tax

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+ Gross Income - Depreciation Allowance - Interest on Borrowed Money - Other Tax Exemptions = Taxable Income

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Ex: Suppose K-Corp earns $5,000,000 in revenue above manufacturing and operations cost. Suppose further that depreciation costs total $800,000 and interest paid on short and long term debt totals $1,500,000. Compute the tax paid.

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Gross Income$ 5,000,000 Depreciation- 800,000 Interest - 1,500,000 Taxable Income$ 2,700,000

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Gross Income$ 5,000,000 Depreciation- 800,000 Interest - 1,500,000 Taxable Income$ 2,700,000 Tax= $ 113,900 +.34(2,700,000 - 335,000) = $936,400

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+ Gross Income - Interest = Before Tax Cash Flow

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+ Gross Income - Interest = Before Tax Cash Flow - Tax = After Tax Cash Flow

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Ex: Suppose K-Corp earns $5,000,000 in revenue above manufacturing and operations cost. Suppose further that depreciation costs total $800,000 and interest paid on short and long term debt totals $1,500,000. Compute the after tax cash flow.

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Gross Income $ 5,000,000 Depreciation- 800,000 Interest - 1,500,000 Before Tax Cash Flow $ 2,700,000

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Gross Income $ 5,000,000 Interest - 1,500,000 Before Tax Cash Flow $3,500,000 Less Tax $936,400 After Tax Cash Flow $2,563,600

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Straight Line (SL) Sum-of-Years Digits (SYD) Declining Balance (DB) Prior to 1981 Accelerated Cost Recovery System (ACRS) 1981-86 Modified Accelerated Cost Recovery (MACRS) 1986 on

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Let P = Initial Cost n = Useful Life s = Salvage Value year n D t = Depreciation Allowance in year t B t = Unrecovered Investment (Book Value) in year t Then D t = (P - S) / n B t = P - [ (P - S) / n ] t

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Let P = $100,000 n = 5 years s = $ 20,000 Then D t = (P - S) / n = $ 16,000 B 5 = P - [ (P - S) / n ] 5 = $ 20,000

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In declining balance, we write off a constant %, p, of remaining book value D 1 = pP,P = initial cost ‘p= factor/n normally 2/n or 1.25/n or 1.5/n B 1 = P - D 1 = P - pP = P(1-p) D 2 = pB 1 = pP(1-p)

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In declining balance, we write off a constant %, p, of remaining book value B 2 = B 1 - D 2 = P(1-p) - pB 1

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In declining balance, we write off a constant %, p, of remaining book value B 2 = B 1 - D 2 = P(1-p) - pB 1 = P(1-p) - pP(1-p)

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In declining balance, we write off a constant %, p, of remaining book value B 2 = B 1 - D 2 = P(1-p) - pB 1 = P(1-p) - pP(1-p) = P(1-p)[1 - p]

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In declining balance, we write off a constant %, p, of remaining book value B 2 = B 1 - D 2 = P(1-p) - pB 1 = P(1-p) - pP(1-p) = P(1-p)[1 - p] = P(1-p) 2

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In declining balance, we write off a constant %, p, of remaining book value B 2 = B 1 - D 2 = P(1-p) - pB 1 = P(1-p) - pP(1-p) = P(1-p) 2 D t = p [ P (1 - p) t - 1 ] B t = P (1 - p) t

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P = $100,000 n = 5 years S = $20,000 p = 2/5 (200% declining balance) Then D 1 = (2/5)(100,000) = $40,000 D 5 = ?,B 5 = ?

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P = $100,000 n = 5 years S = $20,000 p = 2/5 (200% declining balance) Then D 1 = (2/5)(100,000) = $40,000 B 1 = 100,000 - 40,000 = $ 60,000 D 5 = ?,B 5 = ?

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P = $100,000 n = 5 years S = $20,000 p = 2/5 (200% declining balance) Then D 1 = (2/5)(100,000) = $ 40,000 B 1 = 100,000 - 40,000 = $ 60,000 D 2 = (2/5)(60,000) = $ 24,000 D 5 = ?,B 5 = ?

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D t = p [ P (1 - p) t - 1 ] D 5 =.4(100,000)(.6) 4 = $ 5,184 B t = P (1 - p) t B 5 = 100,000(.6) 5 = $ 7,776

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D t = p [ P (1 - p) t - 1 ] D 5 =.4(100,000)(.6) 4 = $ 5,184 B t = P (1 - p) t B 5 = 100,000(.6) 5 = $ 7,776 Note that Declining Balance will never depreciate book value to $0. It will, however, depreciate past the salvage value

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MACRS are built off of this Pick the Maximum Depreciation between Straightline Depreciation & Declining Balance. Year 1 SL = (Book Value/n)*.5 Year 1 Declining balance = P/2*Book Value Year 1 Depreciation = Max Depreciation of SL and Declining Balance Year 2-Year N-1 SL Depreciation= Book Value t-1 /(n-t+.5) Year 2 - Year N-1 Declining Balance Depreciation= Book Value t-1 *P

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Ex: Suppose K-Corp is interested in purchasing a new conveyor system. The cost of the conveyor is $180,000 and may be depreciated over a 5 year period. K-Corp uses 150% declining balance method with a conversion to straight line. Compute the depreciation schedule over the 5 year period.

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A $180,000 piece of machinery is installed and is to be depreciated over 5 years. You may assume that the salvage value at the end of 5 years is $ 0. The method of depreciation is to be double declining balance with conversion to straight line using the half-year convention (you may only deduct 1/2 year of depreciation in year 1). Establish a table showing the depreciation and the end of year book value for each year.

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Property Classes 3 yr. - useful life < 4 yrs. autos, tools 5 yr. - 4 yrs. < useful life < 10 yrs. office equipment, computers, machinery 7 yr. - 10 < UL < 16 office furniture, fixtures, exploration 10 yr. - 16 < UL < 20 vessels, tugs, elevators (grain) 15 yr. - 20 < UL < 25 data communication, sewers, bridges, fencing

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20 yr. - UL > 25 farm buildings, electric generation 27.5 - residential rental property 31.5 - non-residential real property Depreciation class (3, 5, 7, 10 yr.) uses 200% declining balance switching to straight-line @ optimal year class (15, 20) 150% DB switch to SLD class (27.5, 31.5) use straight-line

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Formulas BTCF = Before Tax Cash Flow = Revenues - Expenses

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Formulas BTCF = Before Tax Cash Flow = Revenues - Expenses TI = Taxable Income = Cash Flow - Interest - Depreciation

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Formulas BTCF = Before Tax Cash Flow = Revenues - Expenses TI = Taxable Income = Cash Flow - Interest - Depreciation Tax = TI * Tax Rate

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Formulas BTCF = Before Tax Cash Flow = Revenues - Expenses TI = Taxable Income = Cash Flow - Interest - Depreciation Tax = TI * Tax Rate ATCF = After Tax Cash Flow = BTCF - Tax

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A company plans to invest in a water purification system (5 year property) requiring $800,000 capital. The system will last 7 years with a salvage of $100,000. The before-tax cash flow for each of years 1 to 6 is $200,000. Regular MACRS depreciation is used; the applicable tax rate is 34%. Construct a table showing each of the following for each of the 7 years.

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Straight Line with either a half-year or half-month convention. Required for property outside U.S. having tax-exempt status financed by tax-exempt bonds covered by executive order

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Ex: A press forming machine is purchased for the manufacture of steel beams for $300,000. The press is considered a 7 year property class (MACRS-GDS = 7). Compute the annual depreciation using the MACRS Alternative Depreciation Election.

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Soln: MACRS - ADS has a longer life than does MACRS - GDS. In this case 14 years. D n = $300,000/14 = $21,428n = 2,..., 14 = $21,428 / 2 = $10,714n = 1, 15

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Allows for equal depreciation for each unit of output where U t = units produced during the year U = total units likely to be produced during life (P-F) = depreciable amount allowed

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Allows for equal depreciation for each unit of output where Q t = total hours used during the year Q = total hours available during the year (P-F) = depreciable amount allowed Q Q FPD t t )(

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Allows for equal depreciation for each unit of output where R t = rent income earned during the year R = total likely rent to be earned during life (P-F) = depreciable amount allowed R R FPD t t )(

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Allows for equal depreciation for each unit of output where V t = volume extracted during the year V = total volume available in reserve (P-F) = depreciable amount allowed V V FPD t t )(

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Ex: NorCo Oil has a 10 year, $27,000,000 lease on a natural gas reservoir in western South Dakota. The reservoir is expected to produce 10 million cubic ft. of gas each year during the period of the lease. Compute the expected depletion allowance for each year.

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Ex:

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Depletion is taken as a constant percentage of gross income Allowable Percentages Oil/Gas15% Natural Gas22% Sulphur/Uranium22% Gold, silver, …15% Coal 10%

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Ex: NorCo Oil has a 10 year, $27,000,000 lease on a natural gas reservoir in western South Dakota. The reservoir is expected to produce 10 million cubic ft. of gas each year during the period of the lease at $1.50 per cubic ft. Gross Income = 1.5(10,000,000) = 15,000,000 Depletion= 15,000,000 (0.22) = $3,300,000

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Compute net long/short term gains or losses Short-term gains$20,000 Short-term losses- 28,500 Net short term loss($ 8,500) Long term gains 85,000 Long term losses- 19,500 Net long term gain$ 65,500

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Compute net long/short term gains or losses Net long term gain$ 65,500 Net short term loss($ 8,500) Net Capital gain$ 57,000

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Compute net long/short term gains or losses Net long term gain$ 65,500 Net short term loss($ 8,500) Net Capital gain$ 57,000 Taxed as ordinary (35%) $ 19,950 Taxed at capital gain (28%) $ 15,960

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K-Corp earned $ 750,000 as ordinary income and has $100,000 in net capital gain. Compute the tax on the net capital gain.

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Taxed at ordinary (34%)34,000 Taxed at capital (28%)28,000 Tax at capital gain rate$28,000

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K-Corp earned $ 60,000 as ordinary income and has $100,000 in net capital gain. Compute the tax on the net capital gain.

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Taxed at ordinary (25%) 25,000 Taxed at capital (28%) 28,000 Tax at ordinary rate$25,000

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LOSS K-Corp earned $ 300,000 as ordinary income and has $100,000 in net capital LOSS. Compute the tax on the net capital gain.

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3 5 A Net Capital Loss may be carried back up to 3 years or carried forward up to 5 years to offset other net capital gains.

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Suppose K-Corp had the following NI, Gains, and taxes in the 3 previous years. 1995 1996 1997 Net Income500,000700,000650,000 Capital Gain(80,000)120,000 50,000 Tax170,000238,000221,000 Gain Tax 0 33,600 14,000 Total Tax170,000271,600235,000

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We would carry this year’s net loss back to 1996 to offset net capital gain giving 1995 1996 1997 Net Income500,000700,000650,000 Capital Gain(80,000) 20,000 50,000 Tax170,000238,000221,000 Gain Tax 0 5,600 14,000 Total Tax170,000243,600235,000

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Ex: K-Corp purchases a Loader for $250,000 which has a 7 year property class life. After 3 years, $140,675 has been depreciated and the book value is now $109,325. K-Corp now sells the loader for $150,000.

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Recapture = 150,000 - 109,325 = $40,675

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Ex: K-Corp purchases a Loader for $250,000 which has a 7 year property class life. After 3 years, $140,675 has been depreciated and the book value is now $109,325. K-Corp now sells the loader for $150,000. Recapture = 150,000 - 109,325 = $40,675 $40,675 taxed as ordinary income

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Ex: Suppose K-Corp were able to sell this same loader for $ 275,000. Capital Gain = 275,000 - 250,000 = $25,000 Depr. Recapture = 250,000 - 109,325 = $140,675

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Ex: Suppose K-Corp were able to sell this same loader for $ 275,000. Capital Gain = 275,000 - 250,000 = $25,000 Depr. Recapture = 250,000 - 109,325 = $140,675 $ 25,000 taxed at 28% $140,675 taxed at 35%

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Non residential or commercial real property IfThen F t > PF t - P is section 1231 capital gain B t < F t < PF t - B t recaptured as ordinary income F t < B t B t - F t is section 1231 loss

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Non residential or commercial real property IfThen F t > PF t - P is section 1231 capital gain B t < F t < PF t - B t recaptured as ordinary income F t < B t B t - F t is section 1231 loss Residential or Commercial real property IfThen B t < F t F t - B t is section 1231 gain F t < B t B t - F t is section 1231 loss

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Designed for small businesses, Section 179 expense deduction allows taxpayers to elect, in the year certain tangible property is placed in service, to treat the cost as an expense rather than a capital expenditure. The Small Business Jobs Act of 2010 allowed up to $500,000 to be deducted for businesses with total asset purchases of $2,000,000 or less for tax years beginning in 2010 and 2011.* (The amount deducted is reduced by the amount the aggregate cost of qualifying property exceeds $2,000,000.) *The 2010 Tax Relief Act set the maximum Sec. 179 expense for 2012 at $125,000 for purchases up to $500,000 in eligible assets. Because 2012 is an election year, changes are anticipated in Sec. 179 deductions.

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