Doing Taxes ©2004 Dr. B. C. Paul

Example  Partly Poopers Inc (A division of Badish Petroleum) runs a private sewerage treatment facility for the town of Smarterville. Their unique process digests the organic stuff in the sewerage to make natural gas, gasoline, and a yellow soda called Mountain Doodo. They also mine industrial minerals out of limestone and then backfill the underground openings with the solids (crap?) left over from their digestion process.

This year they have the following Incoming Cash Flows  Poop processing charges to Smarterville - $900,000  Sale of Land with depleted mineral reserves and backfilled with all kinds of – well you know what.  $400,000  Sale of Old WW equipment $1,100,000  Natural Gas Sales $1,400,000  Gasoline Sales $1,000,000  Mountain Doodo $1,200,000  Mineral Sales $1,500,000

Task #1 Separate The Income and Capital Gains Revenue Streams  Income  Poop Processing $900,000  Natural Gas Sales $1,400,000  Gasoline Sales $1,000,000  Mountain DoDo $1,200,000  Limestone $1,500,000  Total Gross Income $6,000,000  Capital Gains Category  Used equipment $1,100,000  Land $400,000  Total Income in Capital Gains Area $1,500,000

Partly Poopers Outgoing Cash Flow  Personnel $600,000  Utilities $250,000  Royalties on Limestone $70,000  New Equipment for Plant $1,700,000  Property Taxes to County $90,000  Insurance $65,000  Bought new land $800,000  New CO2 well $195,000  Materials Handling Solids $300,000  Mining Costs for Limestone $345,000  Mine Development workings $250,000  Interest on Loans $500,000

Task #2 – Separate Out Things that Can be Expensed  Personnel $600,000  Utilities $250,000  Royalties $70,000  Property Tax $90,000  Insurance $65,000  Materials Handling $300,000  Mining $345,000  Interest on Loans $500,000

Our Problem Children  Land $800,000  CO2 Well $195,000  New Equipment $1,700,000  Mine Development Workings $250,000

Items that go to Depreciation  New Equipment $1,700,000

What About the Land  $800,000 for Land  Land is not expensible or depreciable  Issue here is that the Land came with mineral rights which Partly Poopers will use  Have to separate  Lets suppose $600,000 for land  Capital Asset – no immediate tax impact  $200,000 for mineral rights  Mineral Rights will go into cost basis for Depletion

The Well Problem  We have $195,000 in a gas well  Well drilling costs can be site prep, set-up, operation of drilling  These are called intangible drilling costs  Because they are essentially used up as you go they can be  Expensed (the usual)  Can elect to put them in cost basis for depletion (seldom done)  Some aspects of drilling create hard tangible assets  Pumps, pipes etc.  Depreciated over 5 years by DDB switching to SL

Splitting up the Well Cost  Suppose 70% intangible, 30% tangible  $136,500 can be expensed  $58,500 capitalized  This means we will be adding $136,500 to our Expenses List  We Also Will at $58,500 to our Depreciation List

The Mine Development Expenses  Some costs actually producing rock  These are an expense for the product  Also need to develop tunnels or other such development to get access  This development may serve the operation for years  Pre-production development is subject to a choice (just like Intangible Drilling Costs)  Can expense them  If you do y ou recapture from Depletion  Can depreciate them by unit of production

In this case I’m going to Expense  Added to My Expenses are  $136,500 in intangible drilling costs  $250,000 in preproduction development  Total Expenses $2,606,500

Moving My Income Tax Calculation Forward  Income $6,000,000  Minus Expenses $2,606,500  Subtotal $3,393,500

Now We Get Ready for Our Funny Money Deductions  Depreciation  Amortization  Depletion

The Capitalized Deductions  $1,700,000 worth of equipment  Assume classed as Waste Water Treatment Plant  MACRS has 15 year life  Depreciation is 150% declining balance switching to straight line  Assuming Mid Year Convention  Year 1 depreciation is 5%  We fill out forms to capitalize  We calculate a depreciation deduction of 5%  1,700,000 * (0.05) = $85,000

The Tangible Well Parts  $58,500  5 year Depreciation  Midyear convention 10% 1rst year  $5,850 deduction

Past Items Depreciation  Suppose that the original plant cost $11,000,000 when built 5 years ago  5 th year depreciation (15 year with Midyear Convention) is 6.93% (from tax table)  $11,000,000 * (0.0693) = $762,300  Food production equipment for Mountain Doodo  $1,500,000 installed 3 years ago  Classed as 7 year property (uses 200% declining balance)  3 rd year under Midyear convention 17.49%  $1,500,000 * (.1749) = $262,350

More Previously Capitalized Items  Office Equipment $250,000 purchased 5 years ago  5 year property (200% declining balance)  11.52% (it has switched to SL)  $250,000*(.1152) = $28,800

Units of Production Depreciation  Most companies take tax benefits as quickly as possible (more money quicker)  We’ll elect to expense  Suppose we have some old expenses we put into Units of Production Depreciation  $2,500,000 dollars expended for decline in past  Development provided access to 20,000,000 tons of reserves  This year we produced 200,000 tons from the reserve  $2,500,000 * (200,000/20,000,000) = $25,000

Continuing My Income Tax  $3,393,500 subtotal after Expenses  Subtract Depreciation $1,129,300  Subtotal $2,264,200

Amortization  Depreciation generally occurs on something tangible  Amortization generally occurs on something intangible  Partly Poopers now has to deal with Amortization

Things to Amortize  Developing the business plan and contracts that Partly Poopers used cost  $500,000  Amortize over 5 years by SL  This is last year take $100,000  Bought the proprietary processes, know how and contact network when business started  $3,000,000  Called Section 197 intangibles  Amortize over 15 years by SL  This year take $200,000

More Amortization  Bought the poop to gasoline patent for $2,000,000 – has 10 more years  Amortize by SL over the life of asset  Take $200,000 this year  Leased the land for the main plant for $1,000,000 for 50 years  Amortize by SL over asset life  Take $20,000 this year

Totaling Up Amortization  Amortization total $520,000  Continuing With My Tax Calculation  Subtotal After Expenses and Depreciation $2,264,200  Minus Amortization $520,000  Subtotal $1,744,200

Now For Depletion  For Depletion we Calculate it Two Ways and Pick the Best  Cost Depletion  Percentage Depletion

Our Cost Depletion  We finished using up and selling Land this year  Suppose we had $200,000 in mineral rights  Suppose we used 1/4 th of reserves this year  1/4 th of $200,000 is $50,000 of Cost Depletion

Percentage Depletion  Take a % of Gross Sales  Stone sales were $1,500,000  Ordinary stone has a 5% rate  $1,500,000 * (0.05) = $75,000  Determine whether Cost or % Depletion is greater  $50,000 Cost Depletion  $75,000 % Depletion  Take % Depletion

Just One Little Problem  Original exploration for the deposit (before production)  Can elect to put it into cost basis for cost depletion  Often avoided because can see % depletion is normally taken  Can elect to expense  If you do – it is “recaptured” from depletion  Suppose have $325,000 we deducted 5 years ago  Suppose we have had $75,000 in depletion each year for last 4 years  We didn’t actually get to take it – now “recaptured” - $300,000  Means the Tax man is still out to recapture $25,000  Our Depletion adjusted for Recapture is $50,000  Are number of tax situations and benefits mostly from creative finance that trigger recapture.

My Income Tax  Subtotal After Expenses, Depreciation, Amortization $1,744,200  Minus Depletion $75,000  Add Recapture $25,000  Taxable Income = $1,694,200

Actual Income Tax has strange brackets  Lets just use 36% flat  $1,694,200*0.36 = $609,912 due in income tax.

Now For Capital Gains Tax  We Sold Two Capital Assets this year  Equipment $1,100,000  Land $400,000

Capital Gains on Equipment  The equipment  Original Cost was $1,500,000  We depreciated for 3 years  Our cumulative Depreciation is  $1,500,000*( )= $844,050  Book Value is $1,500,000-$844,050 = $655,950  We Sold for $1,100,000 - $655,950 = $444,050 in Capital Gains

We Figure All Our Capital Gains and Losses for the Year  The Land  Bought $800,000  Attributed $200,000 to the mineral rights  $600,000 in Land itself  Sold for $400,000  $400,000 - $600,000 = -$200,000 (A capital loss)

Now Total Our Gains and Losses  Equipment Gain $444,050  Land Loss -$200,000  Total Gain is $244,050  Calculate Our Capital Gains Tax  $244,050 * 0.36 = $87,858