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Chapter 12 Income Taxes

Chapter 12 Income Taxes. Chapter Outline. Individual income taxes Corporate income taxes Income tax rates at federal and state levels Capital gains and losses for non-depreciated assets After-tax cash flows and after-tax rate of return Spreadsheets and after-tax cash flows.

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Chapter 12 Income Taxes

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  1. Chapter 12 Income Taxes

  2. Chapter Outline • Individual income taxes • Corporate income taxes • Income tax rates at federal and state levels • Capital gains and losses for non-depreciated assets • After-tax cash flows and after-tax rate of return • Spreadsheets and after-tax cash flows ENG3615-Engineering Economics

  3. Learning Objectives • Taxes and tax tables • Calculate taxes for both individuals and corporations • Determine the combined income tax rates and marginal income tax rates • Develop after-tax cash flows for a project • Evaluate an investment on an after-tax basis including asset disposal • Use spreadsheet in solving after-tax economic analysis problems ENG3615-Engineering Economics

  4. Vignette: On with the Wind • Technology for renewable energy has been available for many years. • Transition to greater use of wind power requires a significant investment. • Federal tax law in the Energy Policy Act of 1992 allowed utilities a “production tax credit” of 1.5¢ per kWh. • With the tax credit and the advances in technology, many wind plants can now produce power for less 5¢ per kWh. ENG3615-Engineering Economics

  5. Vignette: On with the Wind • Should government support wind energy through tax credit? • What are the costs and benefits of wind technology from the perspectives of the producers, consumers, and society in general. Are there any ethical issues? • What is the effect on wind energy investment if the wind power production tax credit is allowed to expire, or is extended for only a few years? • Using internet, can you determine how tax rates changed throughout the course of the 20th century? How has this affected the value of tax credits to industry? ENG3615-Engineering Economics

  6. Income Taxes • An give an overview of federal income taxes. • Taxes are very complex. Lifetime task • No realistic economic analysis can ignore taxes.  • Tax laws change regularly. E.g. Table 12-1, 2007 Tax Rates for individuals, does not apply for 2010. • Sources of information on taxes include:  • http://www.irs.gov • “Your Federal Income Taxes”, free from IRS by mail • TurboTax (PC software for doing individual taxes) • Individuals and corporations pay taxes. ENG3615-Engineering Economics

  7. A Partner in the Business • U.S. Government is a partner in every business activity • Government shares profits through income taxes • Government shares losses through income taxes Related Point of View: Think of taxes as one more disbursement (like operating costs, maintenance, labor and materials, etc.) ENG3615-Engineering Economics

  8. Taxable Income of Individuals Gross Income - Retirement Contribution - Other Adjustments Adjusted Gross Income (AGI) Gross Income Taxable Income ENG3615-Engineering Economics

  9. Taxable Income of Individuals (2007) ENG3615-Engineering Economics

  10. Taxable Income of Individuals (2009) ENG3615-Engineering Economics

  11. Classification of Business Expenditures • There are three distinct types of business expenditures: • for depreciable assets (e.g. equipment, buildings); • for non-depreciable assets (e.g., land, minerals); • all other business expenditures (e.g., labor, materials). • Expenditures for depreciable assets. See Chapter 11. ENG3615-Engineering Economics

  12. Classification of Business Expenditures • 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. ENG3615-Engineering Economics

  13. Classification of Business Expenditures • 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:  • labor costs; • materials; • all direct and indirect costs; • facilities and productive equipment with a useful life of one year or less. • These are all routine expenditures. ENG3615-Engineering Economics

  14. Classification of Business Expenditures • Recall there are three distinct types of business expenditures: • for depreciable assets;for non-depreciable assets; • all other business expenditures.  • Entering capital expenditures into the accounting records of the firm (the “books”) is called capitalizing them. • Entering all other business expenditures into the accounting records is called expensing them. Capital Expenditures Expense Expenditures ENG3615-Engineering Economics

  15. Example 12-1 Taxable Income • Example: A firm has the following results (in millions of dollars) for a 3-year period. Compute the taxable income for each of the 3 years. • Since the special tooling has a 3-year useful life, it is a capital expenditure. ENG3615-Engineering Economics

  16. Example 12-1 Taxable Income Since the special tooling has a 3-year useful life, it is a capital expenditure. 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. ENG3615-Engineering Economics

  17. Example 12-1 Taxable Income Actual cash flows: Taxable Income: ENG3615-Engineering Economics

  18. Maximum Federal Income Tax Rates for Individuals ENG3615-Engineering Economics

  19. 2007 Individual Tax rates ENG3615-Engineering Economics

  20. 2007 Federal Income Tax Ratesfor Individuals Single Taxpayers ENG3615-Engineering Economics

  21. 2007 Federal Income Tax Ratesfor Individuals Married Individuals Filing Jointly ENG3615-Engineering Economics

  22. 2009 Individual Tax rates ENG3615-Engineering Economics

  23. 2009 Federal Income Tax Ratesfor Individuals Married Individuals Filing Jointly ENG3615-Engineering Economics

  24. 2011 Individual Tax rates ENG3615-Engineering Economics

  25. Example 12-2 - Taxable Income of Individuals An unmarried student earned $10,000 in the summer plus another $6000 during the rest of 2007. He is allowed one exemption and he spent $1000 on allowable itemized deductions. ENG3615-Engineering Economics

  26. Problem 12-4 Taxable Income of Individuals A married couple filing jointly had a combined total adjusted gross income (AGI) of $75,000, and allowable itemized deductions of $4,000 in 2009. Compute their 2009 federal income tax. ENG3615-Engineering Economics

  27. Federal Corporate Income Tax Rates ENG3615-Engineering Economics

  28. 2007 Federal Corporate Income Tax Rates ENG3615-Engineering Economics

  29. Example 12-3 Federal Corporate Income Tax The French Chemical Corp. bought land for $220,000, built a $900,000 factory building, and installed $650,000 worth of chemical equipment. The plant was completed and operation begun on April 1. Gross income for the calendar year was $450,000. All expenses amounted to $100,000. The firm used MACRS for depreciation. ENG3615-Engineering Economics

  30. Table 11-3 MACRS GDS Percentage Rate ENG3615-Engineering Economics

  31. Table 11-4 MACRS GDS Percentage Rate Residential Rental Property Nonresidential Real Property ENG3615-Engineering Economics

  32. Example 12-5Before-tax and After-tax Cash Flows (B-S)/N= (3000-750)/5 = 450 Initial Cost = $3000; Useful life = 5 years; Annual net saving= $800; Salvage value = $750; Assume 34% incr. tax rate IRRAT=10.6% IRRBT=15.7% ENG3615-Engineering Economics

  33. Example 12-5Before-tax and After-tax Cash Flows (B-S)/N= (3000-750)/5 = 450 Initial Cost = $3000; Useful life = 5 years; Annual net saving= $800; Salvage value = $750; Assume 34% incr. tax rate IRRAT=10.6% IRRBT=15.7% ENG3615-Engineering Economics

  34. Example 12-6 After-tax Cash Flows Initial Cost (inventory) = $20,000; Useful life = 4 years; Annual net saving= $1,000, $1,500, $2,000, $2,500; Salvage value = $20,000; IRRAT= 5.2% IRRBT= 8.5% ENG3615-Engineering Economics

  35. 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 (“the books”) reflect this change. If Selling Price > Original Cost Basis, then Capital gain = Selling price – Original Cost Basis ( > 0)   If Selling price < Original Cost Basis, then Capital loss = Selling price – Original Cost Basis (< 0) ENG3615-Engineering Economics

  36. Capital Gains and Losses: Non-depreciated Assets 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 15% for assets held more than 12 months by individuals. See a tax accountant or an attorney for advise here. ENG3615-Engineering Economics

  37. Table 12-5 Tax Treatment of Capital Gains &Losses ENG3615-Engineering Economics

  38. Investment Tax Credit (ITC) • ITC has been used to stimulate capital investments. • Businesses were able to deduct a percentage of their new equipment purchases as a tax credit. • Depending on the specific ITC provisions, the credit might or might not be subtracted from the basis for depreciation. • Tax Reform Act of 1986 eliminated ITC for most assets, although credits are allowed in some specialized cases, such as historical building preservation and in the development of alternate energy sources. ENG3615-Engineering Economics

  39. Estimating the After-Tax Rate of Return • For nondepreciable assets After-tax rate of return = (1 – Incremental tax rate) (Before-tax rate of return) ENG3615-Engineering Economics

  40. =IRR(J2..J7) =Salvage – BV =750.00 – 345.60 =Taxed BTCF – Depr. + Recap. Depr. =800.00 – 172.80 + 404.40 Example 12-7 Calculation of the After-Tax Rate of Return ENG3615-Engineering Economics

  41. End of Chapter 12 ENG3615-Engineering Economics

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