Corporate Taxes Lecture No.21 Chapter 8 Fundamentals of Engineering Economics Copyright © 2008

Gross Income Expenses Cost of goods sold (revenues) Depreciation Operating expenses Taxable income Income taxes Net income (Accounting Profit) Item How to Determine “Accounting Profit”

ItemAmount Gross income (revenue)$50,000 Expenses Cost of goods sold Depreciation Operating expenses 20,000 4,000 6,000 Taxable income20,000 Taxes (40%)8,000 Net income$12,000 Example 8.8- Net Income Calculation

Capital Expenditure versus Depreciation Expenses Not Cash Expenses

Example 8.9 Cash Flow from Operation versus Net Income

Net income : Net income is an accounting means of measuring a firm’s profitability based on the matching concept. Costs become expenses as they are matched against revenue. The actual timing of cash inflows and outflows are ignored. Cash flow : Considering the time value of money, it is better to receive cash now than later, because cash can be invested to earn more money. So, cash flows are more relevant data to use in project evaluation. Cash Flow vs. Net Income

ItemIncomeCash Flow Gross income (revenue$50,000 Expenses Cost of goods sold Depreciation Operating expenses 20,000 4,000 6, ,000 -6,000 Taxable income20,000 Taxes (40%)8,000-8,000 Net income$12,000 Net cash flow$16,000 Example 8.9 – Cash Flow versus Net Income

U.S. Corporate Tax Rate (2008) Taxable income 0-$50,000 $50,001-$75,000 $75,001-$100,000 $100,001-$335,000 $335,001-$10,000,000 $10,000,001-$15,000,000 $15,000,001-$18,333,333 $18,333,334 and Up Tax rate 15% 25% 34% 39% 34% 35% 38% 35% Tax computation $ (  $7, (  $13, (  $22,  $113,  $3,400,  $5,150,  $6,416,  (  denotes the taxable income in excess of the lower bound of each tax bracket

Marginal and Effective (Average) Tax Rate for a Taxable Income of $16,000,000 Taxable incomeMarginal Tax Rate Amount of Taxes Cumulative Taxes First $50,00015%$7,500 Next $25,00025%6,25013,750 Next $25,00034%8,50022,250 Next $235,00039%91,650113,900 Next $9,665,00034%3,286,1003,400,000 Next $5,000,00035%1,750,0005,150,000 Remaining $1,000,000 38%380,000$5,530,000

Example Corporate Income Taxes Facts: Capital expenditure$100,000 (allowed depreciation) $58,000 Gross Sales revenue $1,250,000 Expenses: Cost of goods sold$840,000 Depreciation $58,000 Leasing warehouse $20,000 Question: Taxable income?

 Taxable income: Gross income$1,250,000 - Expenses: (cost of goods sold) $840,000 (depreciation) $58,000 (leasing expense) $20,000 Taxable income $332,000  Income taxes: First 15% $7,500 25% $6,250 34% $8,500 39% $90,480 Total taxes $112,730 Solution:

 Average tax rate: Total taxes=$112,730 Taxable income =$332,000  Marginal tax rate: Tax rate that is applied to the last dollar earned 39%

Disposal of Depreciable Asset  If a MACRS asset is disposed of during the recovery period,  Personal property: the half-year convention is applied to depreciation amount for the year of disposal.  Real property: the mid-month convention is applied to the month of disposal.

Taxable Gains (or Losses)  Case 1: Salvage value < Cost basis: gains (losses) = salvage value – book value  Case 2: Salvage value > Cost basis: gains = salvage value – book value = (salvage value - cost basis) capital gains + (cost basis – book value) ordinary gains ordinary gains (depreciation recapture) Depreciation recapture is taxed as ordinary income.

Determining Ordinary Gains and Capital Gains

Example 8.11 Gain or Loss on a Depreciable Asset

 Explicit consideration of taxes is a necessary aspect of any complete economic study of an investment project.  Once we understand that depreciation has a significant influence on the income and cash position of a firm, we will be able to appreciate fully the importance of utilizing depreciation as a means to maximize the value both of engineering projects and of the organization as a whole. Summary

 For corporations, the U.S. tax system has the following characteristics: 1. Tax rates are progressive: The more you earn, the more you pay. 2. Tax rates increase in stair-step fashion: four brackets for corporations and two additional surtax brackets, giving a total of six brackets. 3. Allowable exemptions and deductions may reduce the overall tax assessment.

 Marginal tax rate is the rate applied to the last dollar of income earned;  Average (effective) tax rate is the ratio of income tax paid to net income; and  Incremental tax rate is the average rate applied to the incremental income generated by a new investment project.  Ordinary gains are taxed as ordinary income.  Capital gains are currently taxed as ordinary income, and the maximum rate is capped at 35%.  Capital losses are deducted from capital gains; net remaining losses may be carried backward and forward for consideration in years other than the current tax year.

 Because it employs accelerated methods of depreciation and shorter-than-actual depreciable lives, the MACRS (Modified Accelerated Cost Recovery System) gives taxpayers a break: It allows them to take earlier and faster advantage of the tax-deferring benefits of depreciation.  The total amount of taxes to pay remains unchanged regardless of depreciation methods adopted. It only changes the timing of the payment.

 Given the frequently changing nature of depreciation and tax law, we must use whatever percentages, depreciable lives, and salvage values mandated at the time an asset is acquired.