MER 439 - Design of Thermal Fluid Systems Engineering Economics B asics of Taxation

1. MER 439 - Design of Thermal Fluid Systems Engineering EconomicsBasics of Taxation Professor Anderson Spring Term 2012

2. Basics of Taxation For Corporations • Corporations pay taxes on income generated while doing business • When performing an economic analysis one must determine if it is a before or after tax analysis • For tax-exempt organizations it is not necessary • Most analysts do after tax analyses

3. Definitions • Gross Income - (GI) Total of all income from revenue producing sources • Expenses - (E) All costs incurred while transacting business • Taxable Income - (TI) The dollar value remaining upon which taxes are to be paid. • TI = Gross Income – Expenses – Depreciation

4. Definitions Continued Capital Gain: Gain incurred when the selling price an asset or real property exceed the purchase price (unadjusted basis) Capital Gain = Selling Price – Unadjusted Basis STG= Short Term Gain < 1 y or 6 months LTG= Long Term Gain > 1 yr or 6 months

5. Definitions Continued Capital Loss: Selling Price is Less than BV Capital Loss = BV- Selling Price Short term (STL), Long Term (LTL) Recaptured Depreciation: RD = Selling Price – BV > 0

6. Basic Tax Formulas and Computations Taxes = (GI – E – D)*T = TI*T T = Tax Rate Corporate Federal Income Tax Rate Schedule Taxable Income Tax Rate Corporate Income Tax < $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 $100k $335,000-10 mil 34% $113,900+34% over $335k $10 mil-15 mil 35% $3.4 mil+35% over $10 mil >$15 mil 38% $5.159 mil+38% over $15 mil

7. Example A company has a GI = $2,750,000 with expenses and depreciation = $1,950,000. Compute the federal tax. TI = $2,750,000-1,950,000 = $800,000 Taxes = 113900 + 0.34*(800,000-335,000) Taxes = $272,000 Average Tax Rate=Total taxes paid/TI =$272,000/$800,000 =0.34

8. Effective Tax Rate Accounts for all taxes (federal and state) Te = state rate + (1-state rate)(federal rate) That is, Te= state rate + federal rate - (state rate)(federal rate) Taxes=TI x Te

9. Cash Flow Terms CFBT: Cash Flow Before Taxes CFAT: Cash Flow After Taxes CFBT=Gross Income - Expenses TI = CFBT – Depreciation Taxes = TI*T CFAT = CFBT - Taxes

10. The Effect of Depreciation on Taxes • The amount of taxes incurred is affected by the depreciation model chosen • Accelerated methods require less taxes in the early years • Assumptions: • Constant tax rate • Gross Income exceeds Annual Depreciation • Capital recovery down to same SV • Same number of years • Then • Total taxes paid are equal for any depreciation models • The PW of taxes, Ptax, are less for accelerated depreciation models

11. Example Construct the CF diagram for taxes and calculate the PW of taxes for a $9000, 5 year recovery asset if the effective tax rate is 40%. CFBT is estimated at $10,000 per year and the interest rate is 12% per year, Use the 150% declining balance method of depreciation

12. Solution d = 1.5/n = 1.5/5 = 0.3 B = $9000 Dt = dB(1-d)t-1= 0.3(9000)(0.7)t-1 Ptaxes = $12,094