Principles of Taxation

1. Principles of Taxation Chapter 6Property Acquisitions and Cost Recovery Deductions

2. Objectives • Expense versus capitalize. • Define tax basis and adjusted basis. • Show how leverage reduces the after-tax cost of assets. • Compute cost of goods sold. • Use recovery period, method and convention to compute MACRS depreciation. • Explain the limited expensing election. • Understand role of depreciation in NPV of after-tax cash flows. • Amortize intangibles, deplete resources.

3. Expense vs. Capitalize • Deduction permitted for all “ORDINARY AND NECESSARY” business expenses. • Deduction prohibited for “PERMANENT improvements to increase the value of property.” • Some types of capitalized costs can be recovered through amortization or depreciation.

4. Expense vs. Capitalize • Repairs and maintenance? Source of IRS dispute due to facts. • Are environment cleanup and prevention costs expensed or capitalized? • Capitalize expenditures that increase the _________ or _______ ______ of an asset.

5. Tax Subsidies Permit Expensing • R&D expenses (this is BIG). • Allowing deduction for R&D is a tax subsidy. What is the GAAP rationale for requiring expense under SFAS 2? • Y2K costs - IRS has ruled these can be expensed. • Various oil and gas: IDC, depletion • The IRS allows deductions for advertising. Why might this be considered an asset in the absence of specific allowance?

6. Tax Basis • Tax basis = unrecovered cost. • Starting basis generally equals COST basis: • original purchase price, or • _________ of asset if cost more difficult to measure. • When do you recover the cost? Depreciation or sale. Example: For depreciable equipment, adjusted basis is the original basis reduced by depreciation. You can think of adjusted basis as being the tax equivalent of “net book value” of the asset, but with tax depreciation instead of book depreciation.

7. Tax Basis and Leverage • If you buy an asset with $500 cash and $4500 debt, what is the cost basis? • Deductions for interest and cost recovery (depreciation) can improve NPV of after-tax cash flows. AP1, 2 • Study example in text regarding After-Tax Cost of Leveraged Purchase. Note especially the footnote describing the effect of borrowing rate versus internal discount rate. • Tax deductions made some leveraged tax shelters in early 1980’s had positive NPV even when pre-tax flows were breakeven or negative. Chapters 9 and 15 will discuss limits on such tax shelter losses.

8. Cost Recovery • Cost of goods sold • Depreciation • Amortization • Depletion

9. Cost of goods sold • Similar to GAAP 1) Beginning inventory 2) PLUS_____________ 3) = inventory available for sale 4) MINUS_________ ____________ 5) = CGS • Tax versus GAAP differences may occur in capitalization of indirect costs. Tax requires “uniform capitalization” under Section 263. AP4

10. Cost of Goods Sold • Uniform capitalization rules (IRC Section 263) • What indirect costs must be capitalized? • Examples? Officers’ comp (VP Mfg.), employee benefits, building rent, insurance, depreciation.Why might there be book-tax differences in indirect costs being capitalized?

11. Cost of Goods Sold • What are permissible inventory methods? Which ones require book-tax conformity? • 1 • 2 • 3 • Which method requires book-tax conformity? • In times of inflation, LIFO reduces book and taxable income.

12. Depreciation • Depreciation applies to tangible assets (things you can touch, versus intangibles like patents, goodwill) that: • lose value over time due to wear and tear, obsolescence. • Does this rule make sense for real estate? • have a reasonably ascertainable__________ _________. • What do you think about artwork?

13. Depreciation • MACRS - Modified Accelerated Cost Recovery System • Fixed recovery methods and periods • Personalty and other short-lived property: • DDB: 3, 5, 7, 10 • 150% DB:15, 20 • Realty: SL method: _____ years residential, _____ years non-residential (specialty realty 20, 25, 50).

14. Depreciation Conventions - Personalty • Table 6-2 incorporates a half-year convention - provides only 1/2 of the regular rate in the year the property is put in service. • When dispose of asset, multiply table amount by 1/2 in the year of sale. • Buy $10,000 of 7-year property in 1997. Sell the property in 1999. What is 1997, 1998 and 1999 depreciation?

15. Depreciation Conventions - Personalty • Exception to mid-year convention: • IF > _____ % personalty is acquired during the last quarter of the year, THEN • Compute depreciation separately for EACH quarter’s acquisition. • See the MID-QUARTER tables. (Instructor hand out in class.) ONLY adjust table amounts in year of disposition. • AP6, TPC 1.

16. Depreciation Conventions - Realty • Mid-month convention. Get 1/2 of a month in month acquired. Built into Table 6-3. Choose column for month put in service. Use this same column throughout the asset life. AP10. • Like personalty, you have to adjust table amount in year of disposition. Get _____ of a month for the month of disposition. • Buy apartment building for $1,000,000 in August 1995. Sell in March 1999. What is depreciation in 1995 - 1999?

17. Depreciation Conventions • What is the purpose of the half-year, midquarter and midmonth conventions? • Balance 1) prevent taxpayer from claiming a full year of depreciation if hold only for a portion of the year against • 2) Easier rules than computing actual days held.

18. Expensing Election • Applies to tangible personalty. • 2001 amount = $_________. See AP8. • Limits: • Expense cannot create a__________ . • Expense reduced $ for $ if purchases > $__________. AP9. • Reduces record keeping, benefit for small businesses. • Planning - if buy a 3-year, 5-year and 7-year asset, which one should you expense?

19. Other Depreciation Details Not in Text • Combination business and personal use property - “listed property” - such as computers, phones, cars. Only use accelerated depreciation if business use > 50%. • Cars have additional depreciation limits per year. • Different depreciation methods apply for Alternative Minimum Tax purposes (Chapter 10, 14).

20. Lease versus Buy • Example in text compares purchasing for cash up-front to an operating lease. • Tax rules are similar to financial rules for determining whether a lease is capital or ordinary. A capital lease is treated like a purchase by the lessee. • A lessee who obtains assets through an operating lease: • gives up interest and depreciation deductions (because lessor still owns the asset), but • doesn’t have deemed debt on financial balance sheet.

21. Amortization of Intangibles • Generally requires a determinable useful life. • Organizational costs are amortizable straight line method over ____ months. • Start-up costs are also amortizable straight line method over ____ months - some exceptions. • Expansion costs may be currently deductible.

22. Leasehold Costs and Improvements • Cost of acquiring lease is amortized over the period of _______ . • Improvements to leased property are capitalized and depreciated according to type of property. What do you suppose happens when lease ends?

23. Purchased Intangibles • Allocate lump-sum price to assets by relative FMVs. • Residual = goodwill. • Tax = ____ years SL, GAAP = ____ years SL. Book-tax difference is temporary under current tax laws.

24. Depletion • Cost depletion = ___________ * __________ / ___________________. • Percentage depletion • statutory % of gross income. See Q18. • Deduct the greater of cost or percentage depletion.

25. Review - Book-Tax Differences • Temporary differences due to: Depreciation, inventory methods, goodwill amortization. (This used to be permanent before 1992 when goodwill was not amortizable for tax.) • AP11. • Permanent differences due to % depletion (in excess of cost).