Chapter 12 Income Taxes 1

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 ENG3615-Engineering Economics

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 ENG3615-Engineering Economics

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. ENG3615-Engineering Economics

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? ENG3615-Engineering Economics

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:  http://www.irs.gov “Your Federal Income Taxes”, free from IRS by mail TurboTax (PC software for doing individual taxes) Individuals and corporations pay taxes. ENG3615-Engineering Economics

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.) ENG3615-Engineering Economics

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 ENG3615-Engineering Economics

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 $100 + 10% 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 ENG3615-Engineering Economics

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 $100 + 10% 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 ENG3615-Engineering Economics

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. ENG3615-Engineering Economics

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. ENG3615-Engineering Economics

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. ENG3615-Engineering Economics

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 ENG3615-Engineering Economics

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 ENG3615-Engineering Economics

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. ENG3615-Engineering Economics

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 ENG3615-Engineering Economics

Maximum Federal Income Tax Rates for Individuals ENG3615-Engineering Economics

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 ENG3615-Engineering Economics

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% ENG3615-Engineering Economics

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% ENG3615-Engineering Economics

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 ENG3615-Engineering Economics

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% ENG3615-Engineering Economics

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 ENG3615-Engineering Economics

Example 12-2 - Taxable Income of Individuals An unmarried student earned $10,000 in the summer plus another $6000 during the rest of 2007. He is allowed one exemption and he spent $1000 on allowable itemized deductions. Gross Income = Adjusted Gross Income (AGI) = $10,000+6000 = $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 ENG3615-Engineering Economics

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 ENG3615-Engineering Economics

Federal Corporate Income Tax Rates Tax Year 2010 2009 2008 2007 2006 2005 2004 and 2003 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% ENG3615-Engineering Economics

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% 7,500 + 25% over 50,000 $75,000-100,000 34% 13,750 + 34% over 75,000 $100,000-335,000 39% 22,250 + 39% over 100,000 $335,000-10 million 113,900 + 34% over 335,000 $10 million-15 million 35% 3,400,000 + 35% over 10 mil. $15 million - 18,333,333 38% 5,150,000 + 38% over 15 mil. over $18,333,333 6,416,667 + 35% over 18,333,333 ENG3615-Engineering Economics

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%(240,744-100,000) = $77,140 ENG3615-Engineering Economics

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 ENG3615-Engineering Economics

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 ENG3615-Engineering Economics

Example 12-5 Before-tax and After-tax Cash Flows (B-S)/N= (3000-750)/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% ENG3615-Engineering Economics

Example 12-5 Before-tax and After-tax Cash Flows (B-S)/N= (3000-750)/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% ENG3615-Engineering Economics

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% ENG3615-Engineering Economics

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 $1200 - $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 400-500 = -$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) ENG3615-Engineering Economics

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. ENG3615-Engineering Economics

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 ENG3615-Engineering Economics

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. ENG3615-Engineering Economics

Estimating the After-Tax Rate of Return For nondepreciable assets After-tax rate of return = (1 – Incremental tax rate) (Before-tax rate of return) ENG3615-Engineering Economics

Example 12-7 Calculation of the After-Tax Rate of Return =Salvage – BV =750.00 – 345.60 =Taxed BTCF – Depr. + Recap. Depr. =800.00 – 172.80 + 404.40 =IRR(J2..J7) ENG3615-Engineering Economics

End of Chapter 12 ENG3615-Engineering Economics