Copyright Oxford University Press 2009 Chapter 12 Income Taxes

Copyright Oxford University Press 2009 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 Chapter Outline

Copyright Oxford University Press 2009 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 investment alternatives on an after-tax basis including asset disposal Use spreadsheet in solving after-tax economic analysis problems Learning Objectives

Copyright Oxford University Press 2009 Taxable Income of Individuals -Personal Exemption(s) -Itemized or Std. Deduction Wages, salary, etc Interest Income Dividends Capital Gains Unemployment Compensation +Other Incomes Gross Income -Retirement Contribution -Other Adjustments Adjusted Gross Income (AGI) Taxable Income

Copyright Oxford University Press 2009 Taxable Income of Individuals 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) Personal Exemption: One exemption per dependent ($3400 for 2007 returns) Standard Deduction: Single taxpayers, $5350 for 2007 returns Married taxpayers filing jointly, $10,700 for 2007 returns

Copyright Oxford University Press 2009 Classification of Business Expenditures Capital Expenses Expenditures for depreciable assets: –For facilities or productive equipment with useful life in excess of one year –Investment recovered through depreciation Expenditures for nondepreciable assets –Land –Other assets not used in a trade, in a business, or for production of income –Assets subject to depletion Operating expenses All ordinary and necessary expenditures, including labor, materials, all direct and indirect costs, facilities and equipment having a life of one year or less

Copyright Oxford University Press 2009 Taxable Income of Business Firms Gross Income -All expenditures except capital expenditures -Depreciation and depletion charges Taxable Income (12-2)

Copyright Oxford University Press 2009 Example 12-1 Taxable Income Year 1Year 2Year 3 Gross income$200 Purchase of special tooling-6000 All other expenditures-140 Cash flows for the year$0$60 Actual cash flows: Taxable Income: Year 1Year 2Year 3 Gross income$200 All other expenditures-140 Depreciation charges-20 Cash flows for the year$40

Copyright Oxford University Press 2009 Maximum and Minimum Federal Income Tax Rates for Individuals

Copyright Oxford University Press Federal Income Tax Rates for Individuals Single Taxpayers Taxable IncomeTax OverBut Not OverBase TaxPlus On Income Over $07,825$0.0010%$0 7,82531, %7,825 31,85077,1004, %31,850 77,100160,85015, %77, ,850349,70039, %160,850 Over 349,700101, %349,700

Copyright Oxford University Press Federal Income Tax Rates for Individuals Married Individuals Filing Jointly Taxable IncomeTax OverBut Not OverBase TaxPlus On Income Over $0$15,650$0.0010%$0 15,65063,7001, %15,650 63,700128,5008, %63, ,500195,85024, %128, ,850349,70043, %195,850 Over 349,70094, %349,700

Copyright Oxford University Press 2009 Example 12-2 Taxable Income of Individuals Taxable Income = AGI - Exemption - Itemized Deduction = $16,000 – 3,400 – 5,350 = $7,250 Gross Income = Adjusted Gross Income (AGI) = $10, = $16,000 An unmarried student earned $10,000 in the summer plus another $6000 during the rest of the year. He is allowed one exemption and he spent $1000 on allowable itemized deductions. Tax = 10%(7,250) = $725

Copyright Oxford University Press 2009 Maximum and Minimum Federal Corporate Income Tax Rates

Copyright Oxford University Press Federal Corporate Income Tax Rates Taxable Income Tax RateCorporate Income Tax Not over $50,00015%15% over 0 $50,000-75,00025%7, % over 50,000 $75, ,00034%13, % over 75,000 $100, ,00039%22, % over 100,000 $335, million34%113, % over 335,000 $10 million-15 million35%3,400, % over 10 mil. $15 million - 18,333,33338%5,150, % over 15 mil. over $18,333,33335%6,416, % over 18,333,333

Copyright Oxford University Press 2009 Average Federal Corporate Income Tax Rates

Copyright Oxford University Press 2009 Example 12-3 Federal Corporate Income Tax Chemical Equipment d 1 = $650000(14.29%) = $92,885 Federal Income Tax = $22,250+39%(240, ,000) = $77,140 Taxable Income = Gross Income – Expenditures – Depr. = $450,000 – 100,000 – 109,256 = $240,744 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. Total first year depreciation =$109,256 Building d 1 = $900,000(1.819%) = $16,371

Copyright Oxford University Press 2009 Combined Federal and State Income Taxes The amount of state taxes paid is deductible in calculating the taxable income for federal taxes Federal income taxes are not deductible in the computation of state taxable income Combined incremental tax rate =  State tax rate + (  Federal tax rate)(1 -  State tax rate)

Copyright Oxford University Press 2009 Selecting an Income Tax Rate for Economy Studies The tax rate to use is the incremental tax rate that applies to the change in taxable income projected in the economic analysis

Copyright Oxford University Press 2009 Economic Analysis taking Income Tax into Account Before-tax cash flow Depreciation Taxable income = Before-tax cash flow - Depreciation Income taxes = Taxable income x Incremental tax rate After-tax cash flow = Before-tax cash flow - Income taxes

Copyright Oxford University Press 2009 Example 12-5 Calculation of After-tax Cash Flows Initial Cost = $3000; Useful life = 5 years; Annual net saving= $800; Salvage value = $750; Year (a) Before-tax Cash Flow (b) Straight-Line Depreciation (c)=(a)-(b)  (Taxable Income) (d) Income Tax (34%) (e)=(a)-(d) After-tax Cash Flow 0 -$ $450$350$ IRR BT =15.7% IRR AT =10.6%

Copyright Oxford University Press 2009 Example 12-6 Calculation of After-tax Cash Flows Initial Cost (inventory) = $20000; Useful life = 4 years; Annual net saving= $1000, 1500…; Salvage value = $20000; Year (a) Before-tax Cash Flow (b) Depreciation (c)=(a)-(b)  (Taxable Income) (d) Income Tax (39%) (e)=(a)-(d) After-tax Cash Flow 0 -$ $1000$ IRR BT = 8.5% IRR AT = 5.2%

Copyright Oxford University Press 2009 Capital Gains and Losses for Non-depreciated Assets If the selling price of the capital asset exceeds the original cost basis, the excess is called capital gain. If the selling price of the capital asset is less than the original cost basis, the difference is a capital loss.

Copyright Oxford University Press 2009 Table 12-5 Tax Treatment of Capital Gains and 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 Capital Gain Taxed as ordinary income Capital Loss 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