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Depreciation Conclusion

Depreciation Conclusion. Taxable Income. + Gross Income - Depreciation Allowance - Interest on Borrowed Money - Other Tax Exemptions = Taxable Income. Corporate Tax Rate. Corporate Tax.

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Depreciation Conclusion

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  1. Depreciation Conclusion

  2. Taxable Income + Gross Income - Depreciation Allowance - Interest on Borrowed Money - Other Tax Exemptions = Taxable Income

  3. Corporate Tax Rate

  4. Corporate Tax Ex: Suppose K-Corp earns $5,000,000 in revenue above manufacturing and operations cost. Suppose further that depreciation costs total $800,000 and interest paid on short and long term debt totals $1,500,000. Compute the tax paid.

  5. Corporate Tax Gross Income $ 5,000,000 Depreciation - 800,000 Interest - 1,500,000 Taxable Income $ 2,700,000

  6. Corporate Tax Gross Income $ 5,000,000 Depreciation - 800,000 Interest - 1,500,000 Taxable Income $ 2,700,000 Tax = $ 113,900 + .34(2,700,000 - 335,000) = $ 918,000

  7. Methods of Depreciation • Straight Line (SL) • Declining Balance (DB) • Prior to 1981 • Modified Accelerated Cost Recovery (MACRS) • Depletion • Sum-of-Years Digits (SYD)

  8. Time Value of Tax Savings(Tax Rate = 40%)

  9. MACRS • Prior to 1981, taxpayers could choose among several methods when depreciating assets for tax purposes. • With the Economic Recovery Act of 1981, ACRS was required and MACRS was instituted in 1986. • MACRS is a simpler, more rapid depreciation method.

  10. MACRS Tables

  11. Modified Accelerated Cost Property Classes 3 yr. - useful life < 4 yrs. autos, tools 5 yr. - 4 yrs. < useful life < 10 yrs. office epuipment, computers, machinery 7 yr. - 10 < UL < 16 office furniture, fixtures, exploration 10 yr. - 16 < UL < 20 vessels, tugs, elevators (grain) 15 yr. - 20 < UL < 25 data communication, sewers, bridges, fencing

  12. MACRS (Cont.) 20 yr. - UL > 25 farm buildings, electric generation 27.5 - residential rental property 31.5 - non-residential real property Depreciation class (3, 5, 7, 10 yr.) uses 200% declining balance switching to straight-line @ optimal year class (15, 20) 150% DB switch to SLD class (27.5, 31.5) use straight-line

  13. Class Problem A company plans to invest in a water purification system (5 year property) requiring $800,000 capital. The system will last 7 years with a salvage of $100,000. The before-tax cash flow for each of years 1 to 6 is $200,000. Regular MACRS depreciation is used; the applicable tax rate is 34%. Construct a table showing each of the following for each of the 7 years.

  14. Solution

  15. Solution

  16. Depletion Method • Allows for equal depreciation for each unit of output where Vt = volume extracted during the year V = total volume available in reserve (I-S) = depreciable amount allowed V = - t D ( I S ) t V

  17. Example Ex: NorCo Oil has a 10 year, $27,000,000 lease on a natural gas reservoir in western South Dakota. The reservoir is expected to produce 10 million cubic ft. of gas each year during the period of the lease. Compute the expected depletion allowance for each year.

  18. Example Ex:

  19. Percentage Depletion • Depletion is taken as a constant percentage of gross income Allowable Percentages Oil/Gas 15% Natural Gas 22% Sulphur/Uranium 22% Gold, silver, … 15% Coal 10%

  20. Example Ex: NorCo Oil has a 10 year, $27,000,000 lease on a natural gas reservoir in western South Dakota. The reservoir is expected to produce 10 million cubic ft. of gas each year during the period of the lease at $1.50 per cubic ft. Gross Income = 1.5(10,000,000) = 15,000,000 Depletion = 15,000,000 (0.22) = $3,300,000

  21. Sum of Years Digits Method SOYD = 1 + 2 + 3 + … + N = N(N+1) 2 Dn = ( N – n + 1 ) ( I – S ) SOYD Bn = Bn–1 – Dn

  22. Depreciation Recapture Ex: K-Corp purchases a Loader for $250,000 which has a 7 year property class life. After 3 years, $140,675 has been depreciated and the book value is now $109,325. K-Corp now sells the loader for $150,000.

  23. Depreciation Recapture Ex: K-Corp purchases a Loader for $250,000 which has a 7 year property class life. After 3 years, $140,675 has been depreciated and the book value is now $109,325. K-Corp now sells the loader for $150,000. Recapture = 150,000 - 109,325 = $40,675

  24. Depreciation Recapture Ex: K-Corp purchases a Loader for $250,000 which has a 7 year property class life. After 3 years, $140,675 has been depreciated and the book value is now $109,325. K-Corp now sells the loader for $150,000. Recapture = 150,000 - 109,325 = $40,675 $40,675 taxed as ordinary income

  25. Depreciation Recapture Ex: Suppose K-Corp were able to sell this same loader for $ 275,000. Capital Gain = 275,000 - 250,000 = $25,000 Depr. Recapture = 250,000 - 109,325 = $140,675

  26. Depreciation Recapture Ex: Suppose K-Corp were able to sell this same loader for $ 275,000. Capital Gain = 275,000 - 250,000 = $25,000 Depr. Recapture = 250,000 - 109,325 = $140,675 $ 25,000 taxed at 28% $140,675 taxed at 35%

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