Income Taxes

1
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

2
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.

3
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.)

4
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
  individuals 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.

5
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)

6
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.

7
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.

8
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 capitalizing them.
• Entering all other business expenditures into the
  accounting records
• is called expensing them.

Capital Expenditures
Expense Expenditures
9
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?

?
10
Individual Tax Rates

• 2003 Tax Rates If you are not married

11
Individual Tax Rates
12
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.

13
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.

15
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.

17
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 firms accounting records
• reflect this change.
•  
• If Selling Price Original Cost Basis
  Capital gain Selling price Original Cost
  Basis ( 0)  
• If Selling price
  Capital loss Selling price Original Cost
  Basis (
• 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

18
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.

19
Economic Analysis Before and After Taxes

• All our earlier analysis of CFSs has been before
  taxes.
• We also need to do a second analysis, after
  taxes.
• Example. Giulianos 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. Giulianos 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.)
21
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.