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Income Taxes Income Taxes Taxable Income of Individuals and Business Firms Classification of Business Expenditures Individual Tax Rates / Corporate Tax Rates Federal and State Taxes Capital Gains and Losses Economic Analysis Before and After Taxes Income Taxes

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Income Taxes

Income Taxes

Taxable Income of Individuals and Business Firms

Classification of Business Expenditures

Individual Tax Rates / Corporate Tax Rates

Federal and State Taxes

Capital Gains and Losses

Economic Analysis Before and After Taxes


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Income Taxes

The goal of this chapter is to give an overview of federal income taxes.

There is so much detail on taxes, you could spend the rest of your working life on the subject and still not know everything about taxes.

Indeed, this is exactly what many tax accountants do.

No realistic economic analysis can ignore taxes. 

  • Tax laws change regularly. For example, Table 12-1, 2003 Tax Rates for individuals, does not apply for 2002.

  • Sources of information on taxes include: 

    1. http://www.irs.gov

    2. “Your Federal Income Taxes” (comprehensive, free publication available from IRS by mail)

     3. TurboTax (very good PC software for doing individual taxes)

  • Both individuals and corporations pay taxes. We will consider basic tax information in each area.


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Income Taxes

  • Basic purpose of taxes:

    to pay for government services.

    For your information, many western European countries charge more taxes than the US – many of them also provide more services than the US does.

  • Helpful Viewpoint for Understanding Taxes:

    Think of U.S. as a partner in every business activity:

    U.S. shares the profits    

  • Related Point of View:

    Think of taxes as one more disbursement

    (like operating costs, maintenance, labor and materials, etc.)


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Taxable Income of Individuals

What is the difference between a taxidermist and a tax collector?

The taxidermist takes only your skin.

Mark Twain

Adjusted gross income = Gross income – Adjustments

Taxable income = Adjusted gross income

- Personal exemption(s)

- Itemized deductions or Standard deduction

  • The tax any individual pays depends on the individual’s gross income.

  • Gross income is the sum of:

    • wages, salary, etc.

    • interest income

    • dividends (e.g., from stocks, mutual funds)

    • capital gains (e.g., from stocks, mutual funds)

    • unemployment compensation

    • other income.

  • Adjusted gross income (AGI) is the difference between gross income and allowable deductions such as retirement plan contributions, or social security income.


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Taxable Income of Individuals

If it weren't for those eleven saving clauses under the head of

"Deductions" I should be beggared every year.

Mark Twain

From adjusted gross income, individuals may deduct:

  • Personal Exemptions. One exemption ($3,050 for 2003) is provided for each person who depends on the gross income for his or her living.

  • Itemized Deductions, including 

    • Excessive medical and dental expenses (exceeding 7.5% of adjusted gross income);

    • State and local income tax;

    • property and personal property tax;

    • Home mortgage interest;

    • Charitable contributions; Casualty and theft losses; Miscellaneous deductions (exceeding 2% of adjusted gross income).

  • Standard Deduction.

    Each taxpayer may either itemize his or her deductions, or else take a standard deduction as follows:

    • Single taxpayers: $4,750 (for year 2003)

    • Married taxpayers filling a joint return: $9,500 (for year 2003)


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Taxable Income of Business Firms

Taxable income = Gross income

- All expenditures but capital expenditures

- Depreciation and depletion charges

Note:

Except for land, business capital expenditures are charged to accounting records period by period through depreciation or depletion charges.


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Classification of Business Expenditures

There are three distinct types of business expenditures:

1. for depreciable assets (e.g., buildings);

2. for non-depreciable assets (e.g., land, minerals);

3. all other business expenditures (e.g., labor, materials).

Expenditures for depreciable assets. This is the subject of Chapter 11.

Expenditures for non-depreciable assets. Non-depreciable assets include:

  • land (land has no finite life);

  • properties not used either in a trade, business, or for the production of income (e.g., home, automobile).

  • Assets subject to depletion (Chapter 11 again).

     Since firms usually acquire assets for use in the business,

    their only non-depreciable assets normally are land and assets subject to depletion.

    All other business expenditures. This is probably the largest category. It includes all the ordinary and necessary expenditures of operating a business, including the following: 

    1. labor costs; 2. materials; 3. all direct and indirect costs;

    4. facilities and productive equipment with a useful life of one year or less.

    These are all routine expenditures.


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Classification of Business Expenditures

Recall there are three distinct types of business expenditures:

1) for depreciable assets2) for non-depreciable assets

3) all other business expenditures 

Entering capital expenditures into the accounting records of the firm

is called capitalizingthem.

Entering all other business expenditures into the accounting records

is called expensing them.

Capital Expenditures

Expense Expenditures


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Taxable Income: Example

Example: A firm has the following results (in millions of dollars) for a three-year period.

For SL depreciation and no salvage value,

the annual depreciation charge is (P-S)/N = (60-0)/3 = $20 million;

taxable income = 200 – 140 – 20 = $40 million for each of the three years.

Do you think the cash results (0,60,60) or the taxable income (40,40,40)

is a better indication of the annual performance of the firm?

?


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Individual Tax Rates

2003 Tax Rates – If you are not married



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Individual Tax Rates: Examples

  • An unmarried person with a taxable income of $50,000 would pay

    $3,960 + 0.27(50,000 – 28,400) = $9,792. 

  • A couple with a taxable income of $50,000 would pay

    $6,517.5 + 0.27 (50,000 – 47,450) = $7,206.

  • A couple with a taxable income of $100,000 would pay

    $ 6,517.5 + 0.27(100,000 – 47,450) = $20,706.

  • Bill is an unmarried student. He earned $8,000 in the summer, plus another $2,000 during the rest of the year. When he files his income tax return, he is allowed one exemption. He estimates he spent $1000 on allowable itemized deductions. How much income tax does he pay?

    • Adjusted gross income (AGI) = $8,000 + 2,000 = $10,000. 

    • Taxable income = AGI – Deduction for one exemption - Standard deduction =

      = 10,000 – 3,050 – 4,750 = $2,200.

    • Federal income tax = 0.10 (2,200) = $222


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Corporate Tax Rates

Income tax for corporations is computed in a manner similar to that for individuals.

Look at the tax rates in page 378.

Note the bracket with a 39% rate between two brackets with 34% rates. (The 5% surtax is to phase out prior tax benefits.)


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Corporate Tax Rates: Example

Example

The French Chemical Corp. was formed to make household bleach. The firm bought land for

$220,000, had a $900,000 factory building erected, and installed $650,000 worth of chemical

and packaging equipment. The plant was completed and operations begin on April 1st. The

gross income for the calendar year was $450,000. Supplies and all operating expenses,

excluding the capital expenditures, were $100,000. The firm will use MACRS depreciation.

Taxable Income = Gross income - All expenditures but capital expenditures - Depreciation and depletion charges

Gross Income =$450,000 Depreciation = $92,885 + $16,371

All expenditures but capital exp. = $100,000

Taxable income = $450,000 - $100,000 - $109,256 = $240,744.

First-year depreciation charge

Chemical equipment is personal property.

Table 11-2 suggests it is probably in the “Seven-year, all other property” class.

Thus, first-year depreciation = 14.29% of $650,000 = $92,885.

The building is in the 39-year real property class.

Being placed in Service April 1st, first-year depreciation = 1.819% of $900,000 = $16,371.

Federal income tax = $22,250 + 0.39(240,744-100,000) = $77,140.


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Federal and State Taxes

  • Most states have an income tax (Florida does not).

  • State taxes are allowable deductions for itemized federal taxes.

  • The converse is not true, unfortunately.

  • Thus state income taxes are based on a larger taxable income than federal income taxes.

    Abbreviations:

    FTR = (Federal Tax Rate) STR = (State Tax Rate)

    Combined taxes = [STR + FTR (1-STR)]( Income)

    Combined incremental tax rate = [STR + FTR (1-STR)]

    Combined taxes = (Combined incremental tax rate)( income)


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Federal and State Taxes: Example

Example

Tom is in the 28% Federal income tax bracket, and the 10% state income tax

bracket. He makes an extra (-incremental) income of $500 consulting.

State income tax = (STR) (Income) = 0.1 (500) = 50

Federal taxable income = Income (1 - STR) = 500 (1- 0.1) = 500 – 50 = 450

Federal income taxes = FTR (Income (1 - STR)) = 0.28 (450) = 126

Combined taxes = (STR) (Income) + FTR (1 - STR) ( Income) = 50 + 126 = $176

= [STR + FTR (1-STR)]  ( Income)

Combined incremental tax rate = [STR + FTR (1-STR)] = 0.1 + 0.28(1 – 0.1) = 0.352

Combined taxes = 0.352 (500) = $176.


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Capital Gains and Losses: Non-depreciated Assets

Non-depreciable assets: land, minerals, stocks, bonds.

Example.

  • Suppose you buy a stock for $1,000, keep it for two years, and sell it for $1,200. The difference $1200 - $1,000 = $200 is called a capital gain.

  • Suppose you buy a stock for $500, keep it for two years, and sell it for $400. The difference 400-500 = -$100 is called a capital loss(a negative capital gain).

    Generalization:

    A firm sells or exchanges a capital asset. Entries in the firm’s accounting records

    reflect this change.

    If Selling Price > Original Cost Basis => Capital gain = Selling price – Original Cost Basis ( > 0)  

    If Selling price < Original Cost Basis => Capital loss = Selling price – Original Cost Basis (< 0)

    Tax laws for treating capital gains change over time.

    Currently, assets held less than six months produce short-term gains or losses.

    Capital assets held for more than six months produce long-term gains or losses.

    The current tax law sets the net capital gains tax at 20% for assets held more

    than12 months by individuals.


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Gains and Losses: Depreciated Assets

In the unlikely event that an asset is sold for an amount greater than its cost basis, the gains (salvage value – book value) are divided into two parts for tax purposes:

Gains = Capital gains + Ordinary gains (Depreciation recapture)

Capital gains = Salvage value – Cost basis

  Ordinary gains = Cost basis – Book value

If asset is sold for an amount less than its book value than

Ordinary loss = Book value - Salvage value

The distinction between capital and ordinary gains is only necessary when capital gains are taxed at the capital gain tax rate and ordinary gains (or depreciation recapture) at the ordinary income tax rate.

This provision could allow Congress to restore preferential treatment for capital gains at some future time.

Capital gains and ordinary gains may be taxed at different rates in the future.


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Economic Analysis Before and After Taxes

All our earlier analysis of CFS’s has been before taxes.

We also need to do a second analysis, after taxes.

Example. Giuliano’s Pizza plans to spend $3,000 on a used truck for the

shipping and receiving department of its local warehouse.

Estimated life = 5 years, Estimated savings per year = $800

Estimated salvage value = $750. Giuliano’s is in the 34% tax bracket.

  SL depreciation = (3000-750)/5 = $450 per year.

Before Taxes: CFS (a) has IRR = 15.69%After Taxes: CFS (e) has IRR = 10.55%


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Economic Analysis Before and After Taxes

After-tax analysis is what is most important.

Income taxes are a major disbursement that cannot be ignored.

Only the after-tax ROR is a meaningful value.

Example

A firm is losing sales because it cannot always make quick deliveries.

By investing an extra $20,000 in inventory it is believed that the before-tax profit of the firm will be $1,000 more the first year. The second year before-tax extra profit will be $1,500.

The extra profit is then expected to go up $500 more each year. The investment in extra inventory may be recovered at the end of a four-year analysis period by selling it and not replenishing the inventory.

Assume the incremental tax rate is 39%.

We wish to find the ROR before taxes, and the ROR after taxes.

Important:

Inventory is not considered a depreciable asset.

The investment in extra inventory is not depreciated.

(Even though an old inventory may have less value to the owner, the tax code does not recognize this.)


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Economic Analysis Before and After Taxes

Before taxes: CFS (a) has IRR = 8.50%

After taxes: CFS (e) has IRR = 5.24%.

Key point: inventory is not considered a depreciable asset, even though its value to the owner may decrease over time.


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