1. Chapter 12 Income Taxes 1

2. Chapter Outline Individual income taxes Corporate income taxes
Income tax rates at federal and state levels
Capital gains and losses for non-depreciated assets
After-tax cash flows and after-tax rate of return
Spreadsheets and after-tax cash flows
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3. Learning Objectives Taxes and tax tables
Calculate taxes for both individuals and corporations
Determine the combined income tax rates and marginal income tax rates
Develop after-tax cash flows for a project
Evaluate an investment on an after-tax basis including asset disposal
Use spreadsheet in solving after-tax economic analysis problems
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4. Vignette: On with the Wind
Technology for renewable energy has been available for many years.
Transition to greater use of wind power requires a significant investment.
Federal tax law in the Energy Policy Act of 1992 allowed utilities a “production tax credit” of 1.5¢ per kWh.
With the tax credit and the advances in technology, many wind plants can now produce power for less 5¢ per kWh.
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5. Vignette: On with the Wind
Should government support wind energy through tax credit?
What are the costs and benefits of wind technology from the perspectives of the producers, consumers, and society in general. Are there any ethical issues?
What is the effect on wind energy investment if the wind power production tax credit is allowed to expire, or is extended for only a few years?
Using internet, can you determine how tax rates changed throughout the course of the 20th century? How has this affected the value of tax credits to industry?
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6. Income Taxes An give an overview of federal income taxes.
Taxes are very complex. Lifetime task
No realistic economic analysis can ignore taxes. 
Tax laws change regularly. E.g. Table 12-1, 2007 Tax Rates for individuals, does not apply for 2010.
Sources of information on taxes include: 
“Your Federal Income Taxes”, free from IRS by mail
TurboTax (PC software for doing individual taxes)
Individuals and corporations pay taxes.
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7. A Partner in the Business
U.S. Government is a partner in every business activity
Government shares profits through income taxes
Government shares losses through income taxes
Related Point of View:
Think of taxes as one more disbursement
(like operating costs, maintenance, labor and materials, etc.)
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8. Taxable Income of Individuals
Wages, salary, etc
Interest Income
Dividends
Capital Gains
Unemployment Compensation
+ Other Income
Gross Income
- Retirement Contribution
- Other Adjustments
Adjusted Gross Income (AGI)
- Personal Exemption(s)
- Itemized or Std. Deduction
Gross Income
Taxable Income
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9. Taxable Income of Individuals (2007)
Personal Exemption:
One exemption per dependent ($3400 for 2007 returns)
Itemized Deduction:
Medical and dental expenses (exceeding 7.5% of AGI)
State and local income, real estate, and personal property tax
Home mortgage interest
Charitable contributions
Casualty and theft losses (exceeding $ % of AGI)
Job expenses and certain miscellaneous deductions (some categories must exceed 2% of AGI)
Standard Deduction:
Single taxpayers, $5,350 for 2007 returns
Married taxpayers filing jointly, $10,700 for 2007 returns
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10. Taxable Income of Individuals (2009)
Personal Exemption:
One exemption per dependent ($3650 for 2009 returns)
Itemized Deduction:
Medical and dental expenses (exceeding 7.5% of AGI)
State and local income, real estate, and personal property tax
Home mortgage interest
Charitable contributions
Casualty and theft losses (exceeding $ % of AGI)
Job expenses and certain miscellaneous deductions (some categories must exceed 2% of AGI)
Standard Deduction:
Single taxpayers, $5,700 for 2009 returns
Married taxpayers filing jointly, $11,400 for 2009 returns
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11. Classification of Business Expenditures
There are three distinct types of business expenditures:
for depreciable assets (e.g. equipment, buildings);
for non-depreciable assets (e.g., land, minerals);
all other business expenditures (e.g., labor, materials).
Expenditures for depreciable assets. See Chapter 11.
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12. Classification of Business Expenditures
Expenditures for non-depreciable assets. Non-depreciable assets include:
land (land has no finite life);
properties not used either in a trade, business, or for the production of income (e.g., home, automobile).
Assets subject to depletion (Chapter 11 again).
Since firms usually acquire assets for use in the business, their only non-depreciable assets normally are land and assets subject to depletion.
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13. Classification of Business Expenditures
All other business expenditures. This is probably the largest category. It includes all the ordinary and necessary expenditures of operating a business, including the following: 
labor costs;
materials;
all direct and indirect costs;
facilities and productive equipment with a useful life of one year or less.
These are all routine expenditures.
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14. Classification of Business Expenditures
Recall there are three distinct types of business expenditures:
for depreciable assets; for non-depreciable assets;
all other business expenditures. 
Entering capital expenditures into the accounting records of the firm (the “books”) is called capitalizing them.
Entering all other business expenditures into the accounting records is called expensing them.
Capital Expenditures
Expense Expenditures
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15. Example 12-1 Taxable Income
Example: A firm has the following results (in millions of dollars) for a 3-year period. Compute the taxable income for each of the 3 years.
Since the special tooling has a 3-year useful life, it is a capital expenditure.
Year 1
Year 2
Year 3
Gross income from sales
$200
Purchase of special tooling (useful life: 3 years)
-$60
All other expenditures
-$140
Cash results for the year $0
$60
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16. Example 12-1 Taxable Income
Year 1
Year 2
Year 3
Gross income from sales
$200
Purchase of special tooling (useful life: 3 years)
-$60
All other expenditures
-$140
Cash results for the year $0
$60
Example 12-1 Taxable Income
Since the special tooling has a 3-year useful life, it is a capital expenditure.
For SL depreciation and no salvage value:
the annual depreciation charge is (P-S)/N = (60-0)/3 = $20 million;
taxable income = 200 – 140 – 20 = $40 million for each of the three years.
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17. Example 12-1 Taxable Income
Actual cash flows:
Year 1
Year 2
Year 3
Gross income
$200
Purchase of special tooling
-60
All other expenditures
-140
Cash flows for the year $0
$60
Taxable Income:
Year 1
Year 2
Year 3
Gross income
$200
All other expenditures
-140
Depreciation charges
-20
Cash flows for the year
$40
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18. Maximum Federal Income Tax Rates for Individuals
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19. 2007 Individual Tax rates 10% $0 15% $7,825 $15,650 $11,200 25%
Single
Married/Joint
Married/Separate
Head of Household
10% $0
15%
$7,825
$15,650
$11,200
25%
$31,850
$63,700
$42,650
28%
$77,100
$128,500
$64,250
$110,100
33%
$160,850
$195,850
$97,925
$178,350
35%
$349,700
$174,850
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20. 2007 Federal Income Tax Rates for Individuals
Single Taxpayers
Taxable Income
Tax
Over
But Not Over
Base Tax
Plus
On Income Over $0
7,825
$0.00
10%
31,850
782.50
15%
77,100
4,386.50
25%
160,850
15,698.75
28%
349,700
39,148.75
33%
Over 349,700
101,469.25
35%
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21. 2007 Federal Income Tax Rates for Individuals
Married Individuals Filing Jointly
Taxable Income
Tax
Over
But Not Over
Base Tax
Plus
On Income Over $0
$15,650
$0.00
10%
15,650
63,700
1,565.00
15%
128,500
8,772.50
25%
195,850
24,972.50
28%
349,700
43,830.50
33%
Over 349,700
94,601.00
35%
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22. 2009 Individual Tax rates 10% $0 15% $8,350 $16,700 $11,950 25%
Single
Married/Joint
Married/Separate
Head of Household
10% $0
15%
$8,350
$16,700
$11,950
25%
$33,950
$67,900
$45,500
28%
$82,250
$137,050
$68,525
$117,450
33%
$171,550
$208,850
$104,425
$190,200
35%
$372,950
$186,475
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23. 2009 Federal Income Tax Rates for Individuals
Married Individuals Filing Jointly
Taxable Income
Tax
Over
But Not Over
Base Tax
Plus
On Income Over $0
$16,700
$0.00
10%
16,700
67,900
1,670.00
15%
137,050
9,350.00
25%
208,850
26,637.50
28%
372,950
46,741.50
33%
Over 372,950
100,894.50
35%
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24. 2011 Individual Tax rates 10% $0 15% $8,500 $17,000 $12,150 25%
Single
Married/Joint
Married/Separate
Head of Household
10% $0
15%
$8,500
$17,000
$12,150
25%
$34,500
$69,000
$46,250
28%
$83,600
$139,350
$69,675
$119,400
33%
$174,400
$212,300
$106,150
$193,350
35%
$379,150
$189,575
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25. Example 12-2 - Taxable Income of Individuals
An unmarried student earned $10,000 in the summer plus another $6000 during the rest of He is allowed one exemption and he spent $1000 on allowable itemized deductions.
Gross Income = Adjusted Gross Income (AGI)
= $10, = $16,000
$1000 (itemized deductions) < $5350 (standard deduc)
Taxable Income = AGI - Exemption – Standard Deduction
= $16,000 – 3,400 – 5,350 = $7,250
Tax = 10%(7,250) = $725
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26. Problem 12-4 Taxable Income of Individuals
A married couple filing jointly had a combined total adjusted gross income (AGI) of $75,000, and
allowable itemized deductions of $4,000 in 2009.
Compute their 2009 federal income tax.
Solution
$4000 (itemized deductions) < $11400 (standard deduc)
Taxable Income = AGI - Exemption – Standard Deduction
= $75,000 – 2(3,650) –11,400 = $56,300
Tax = 10%(16,700) + 15%(56,300 – 16,700) = $7,610
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27. Federal Corporate Income Tax Rates
Tax Year and Federal United States (USA) Corporate Tax Rates
Personal service corporations pay a flat rate of 35%
Taxable income over
But not over
Your tax is
Of the amount over $0
$50,000
15%
$75,000
7,500 +
25%
$100,000
13,750 +
34%
$335,000
22,250 +
39%
$10,000,000
113,900 +
$15,000,000
3,400,000 +
35%
$18,333,333
5,150,000 +
38%
flat rate 35%
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28. 2007 Federal Corporate Income Tax Rates
Taxable Income
Tax Rate
Corporate Income Tax
Not over $50,000
15%
15% over 0
$50,000-75,000
25%
7, % over 50,000
$75, ,000
34%
13, % over 75,000
$100, ,000
39%
22, % over 100,000
$335, million
113, % over 335,000
$10 million-15 million
35%
3,400, % over 10 mil.
$15 million - 18,333,333
38%
5,150, % over 15 mil.
over $18,333,333
6,416, % over 18,333,333
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29. Example 12-3 Federal Corporate Income Tax
The French Chemical Corp. bought land for $220,000, built a $900,000 factory building, and installed $650,000 worth of chemical equipment. The plant was completed and operation begun on April 1. Gross income for the calendar year was $450,000. All expenses amounted to $100,000. The firm used MACRS for depreciation.
Chemical Equipment d1 = $650000(14.29%) = $92,885
Building d1 = $900,000(1.819%) = $16,371
Total first year depreciation = $109,256
Taxable Income = Gross Income – Expenditures – Depr.
= $450,000 – 100,000 – 109,256 = $240,744
Federal Income Tax = $22,250+39%(240, ,000)
= $77,140
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30. Table 11-3 MACRS GDS Percentage Rate
Recovery Year
3-Year
Class
5-Year
7-Year
10-Year Class
15-Year Class
20-Year Class 1
33.33
20.00
14.29
10.00
5.00
3.750 2
44.45
32.00
24.49
18.00
9.50
7.219 3
14.81*
19.20
17.49
14.40
8.55
6.677 4
7.41
11.52*
12.49
11.52
7.70
6.177 5
8.93*
9.22
6.93
5.713 6
5.76
8.92
7.37
6.23
5.285 7
8.93
6.55*
5.90*
4.888 8
4.46
6.55
5.90
4.522 9
6.56
5.91
4.462* 10
4.461 11
3.28
4.462
12-15 16
2.95
17-20 21
2.231
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31. Table 11-4 MACRS GDS Percentage Rate
Residential Rental Property
Recovery
Year
Month Placed in Service 1 2 3 4 5 6 7 8 9 10 11 12
3.485
3.182
2.879
2.576
2.273
1.970
1.667
1.364
1.061
0.758
0.455
0.152
2-27
3.636 28 29
Nonresidential Real Property
Recovery
Year
Month Placed in Service 1 2 3 4 5 6 7 8 9 10 11 12
2.461
2.247
2.033
1.819
1.605
1.391
1.177
0.963
0.749
0.535
0.321
0.107
2-39
2.564 40
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32. Example 12-5 Before-tax and After-tax Cash Flows
(B-S)/N= ( )/5 = 450
Initial Cost = $3000; Useful life = 5 years;
Annual net saving= $800; Salvage value = $750; Assume 34% incr. tax rate
Year
(a)
Before-tax
Cash Flow
(b)
Straight-Line Depreciation
(c)=(a)-(b)
(Taxable Income)
(d)
Income Tax
(34%)
(e)=(a)-(d)
After-tax
-$3000 1
800
$450
$350
$119
681 2
450
350
119 3 4 5
750
IRRBT=15.7%
IRRAT=10.6%
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33. Example 12-5 Before-tax and After-tax Cash Flows
(B-S)/N= ( )/5 = 450
Initial Cost = $3000; Useful life = 5 years;
Annual net saving= $800; Salvage value = $750; Assume 34% incr. tax rate
Year
(a)
Before-tax
Cash Flow
(b)
Straight-Line Depreciation
(c)=(a)-(b)
(Taxable Income)
(d)
Income Tax
(34%)
(e)=(a)-(d)
After-tax
-$3000 1
800
$450
$350
$119
681 2
450
350
119 3 4 5
750
IRRBT=15.7%
IRRAT=10.6%
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34. Example 12-6 After-tax Cash Flows
Initial Cost (inventory) = $20,000; Useful life = 4 years;
Annual net saving= $1,000, $1,500, $2,000, $2,500;
Salvage value = $20,000;
Year
(a)
Before-tax
Cash Flow
(b)
Depreciation
(c)=(a)-(b)
(Taxable Income)
(d)
Income Tax
(39%)
(e)=(a)-(d)
After-tax
-$20000 1
1000
$1000
$390
610 2
1500
585
915 3
2000
780
1220 4
2500
975
1525
20000
IRRBT= 8.5%
IRRAT= 5.2%
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35. Capital Gains and Losses: Non-depreciated Assets
Non-depreciable assets: land, minerals, stocks, bonds.
Example.
Suppose you buy a stock for $1,000, keep it for two years, and sell it for $1,200. The difference $ $1,000 = $200 is called a capital gain.
Suppose you buy a stock for $500, keep it for two years, and sell it for $400. The difference = -$100 is called a capital loss (a negative capital gain).
Generalization:
A firm sells or exchanges a capital asset. Entries in the firm’s accounting records (“the books”) reflect this change.
If Selling Price > Original Cost Basis, then Capital gain = Selling price – Original Cost Basis ( > 0)  
If Selling price < Original Cost Basis, then Capital loss = Selling price – Original Cost Basis (< 0)
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36. Capital Gains and Losses: Non-depreciated Assets
Tax laws for treating capital gains change over time.
Currently, assets held less than six months produce short-term gains or losses.
Capital assets held for more than six months produce long-term gains or losses.
The current tax law sets the net capital gains tax at 15% for assets held more than 12 months by individuals.
See a tax accountant or an attorney for advise here.
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37. Table 12-5 Tax Treatment of Capital Gains & Losses
For Individuals
Capital Gain
For most assets held for less than 1 year, taxed as ordinary income
For most assets held for more than 1 year, taxed at 15% tax rate
Capital Loss
Subtract capital losses from any capital gains; balance may be deducted from ordinary income, but not more than $3000 per year
Excess capital losses may be carried forward indefinitely
For Corporations
Taxed as ordinary income
Deduct capital losses only to the extent of capital gains
Excess capital losses may be carried back 2 years, and, if not completely absorbed, is then carried forward for up to 20 years
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38. Investment Tax Credit (ITC)
ITC has been used to stimulate capital investments.
Businesses were able to deduct a percentage of their new equipment purchases as a tax credit.
Depending on the specific ITC provisions, the credit might or might not be subtracted from the basis for depreciation.
Tax Reform Act of 1986 eliminated ITC for most assets, although credits are allowed in some specialized cases, such as historical building preservation and in the development of alternate energy sources.
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39. Estimating the After-Tax Rate of Return
For nondepreciable assets
After-tax rate of return
= (1 – Incremental tax rate) (Before-tax rate of return)
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40. Example 12-7 Calculation of the After-Tax Rate of Return
=Salvage – BV
= –
=Taxed BTCF – Depr. + Recap. Depr.
= –
=IRR(J2..J7)
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41. End of Chapter 12
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