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
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
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.
2. “Your Federal Income Taxes” (comprehensive, free publication available from IRS by mail)
3. TurboTax (very good PC software for doing individual 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.
Think of U.S. as a partner in every business activity:
U.S. shares the profits
Think of taxes as one more disbursement
(like operating costs, maintenance, labor and materials, etc.)
What is the difference between a taxidermist and a tax collector?
The taxidermist takes only your skin.
Adjusted gross income = Gross income – Adjustments
Taxable income = Adjusted gross income
- Personal exemption(s)
- Itemized deductions or Standard deduction
If it weren't for those eleven saving clauses under the head of
"Deductions" I should be beggared every year.
From adjusted gross income, individuals may deduct:
Each taxpayer may either itemize his or her deductions, or else take a standard deduction as follows:
Taxable income = Gross income
- All expenditures but capital expenditures
- Depreciation and depletion charges
Except for land, business capital expenditures are charged to accounting records period by period through depreciation or depletion charges.
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:
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.
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.
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?
2003 Tax Rates – If you are not married
$3,960 + 0.27(50,000 – 28,400) = $9,792.
$6,517.5 + 0.27 (50,000 – 47,450) = $7,206.
$ 6,517.5 + 0.27(100,000 – 47,450) = $20,706.
= 10,000 – 3,050 – 4,750 = $2,200.
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.)
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.
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)
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.
Non-depreciable assets: land, minerals, stocks, bonds.
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.
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.
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%
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.
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.
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.)
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.