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EGGC4214 EGGC4214 Systems Engineering & EconomySystems Engineering & Economy

Lecture 9Lecture 9Income Taxing SystemsIncome Taxing Systems

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Income TaxesIncome Taxes

The goal of this chapter is to The goal of this chapter is to give an overviewgive an overview of the of the income taxes. There is so much detail on taxes, you could income taxes. There is so much detail on taxes, you could spend the rest of your working life on the subject and still spend the rest of your working life on the subject and still not know everything about taxes. Indeed, this is exactly not know everything about taxes. Indeed, this is exactly what many tax accountants do.what many tax accountants do.

No realistic economic analysis can ignore taxesNo realistic economic analysis can ignore taxes. . – Tax laws change regularly. For example, Table 12-1, Tax laws change regularly. For example, Table 12-1,

2003 Tax Rates for individuals, does not apply for 2002.2003 Tax Rates for individuals, does not apply for 2002.– Sources of information on taxes include: Sources of information on taxes include: 

1. Governmental rates and categories of taxes1. Governmental rates and categories of taxes2. Good PC software for doing individual taxes2. Good PC software for doing individual taxes

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

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Basic purpose of taxes:Basic purpose of taxes: to pay for government to pay for government serviceservices. For your information, some governments s. For your information, some governments charge more taxes than others – many of them also charge more taxes than others – many of them also provide more services than others.provide more services than others.

Helpful Viewpoint for Understanding Taxes:Helpful Viewpoint for Understanding Taxes: Think of the government as your Think of the government as your partnerpartner in every in every business activity.business activity.

Related Point of View:Related Point of View:Think of taxes as Think of taxes as one more disbursementone more disbursement(like operating costs, maintenance, labor and (like operating costs, maintenance, labor and materials, etc.)materials, etc.)

Income TaxesIncome Taxes

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Taxable Income of Taxable Income of IndividualsIndividuals

What is the difference between a taxidermist and a tax collector? What is the difference between a taxidermist and a tax collector? The taxidermist takes only your skin. The taxidermist takes only your skin.

Mark TwainMark Twain

Adjusted gross income = Gross income – AdjustmentsAdjusted gross income = Gross income – AdjustmentsTaxable income = Adjusted gross incomeTaxable income = Adjusted gross income - Personal exemption(s)- Personal exemption(s) - Itemized deductions or Standard deduction - Itemized deductions or Standard deduction

The tax any individual pays depends on the individual’s The tax any individual pays depends on the individual’s gross incomegross income.. Gross incomeGross income is the sum of: is the sum of:

wages, salary, etc.wages, salary, etc. interest incomeinterest income dividends (e.g., from stocks, mutual funds)dividends (e.g., from stocks, mutual funds) capital gains (e.g., from stocks, mutual funds)capital gains (e.g., from stocks, mutual funds) unemployment compensationunemployment compensation other income.other income.

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

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If it weren't for those eleven saving clauses under the head of If it weren't for those eleven saving clauses under the head of "Deductions" I should be beggared every year. "Deductions" I should be beggared every year. Mark Mark

TwainTwain

From adjusted gross income, individuals may deduct:From adjusted gross income, individuals may deduct: Personal ExemptionsPersonal Exemptions: One exemption ($3,050 for 2003 in US) is provided for : One exemption ($3,050 for 2003 in US) is provided for

each person who depends on the gross income for his or her living.each person who depends on the gross income for his or her living.

Itemized DeductionsItemized Deductions, including:, including:• Excessive medical and dental expenses (exceeding 7.5% of adjusted gross Excessive medical and dental expenses (exceeding 7.5% of adjusted gross

income); income); • State and local income tax; State and local income tax; • property and personal property tax;property and personal property tax;• Home mortgage interest; Home mortgage interest; • Charitable contributions; Casualty and theft losses; Miscellaneous Charitable contributions; Casualty and theft losses; Miscellaneous

deductions (exceeding 2% of adjusted gross income).deductions (exceeding 2% of adjusted gross income).

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

• Single taxpayers: $4,750 (for year 2003 in US)Single taxpayers: $4,750 (for year 2003 in US)• Married taxpayers filling a joint return: $9,500 (for year 2000 in US)Married taxpayers filling a joint return: $9,500 (for year 2000 in US)

Taxable Income of Taxable Income of IndividualsIndividuals

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Taxable income = Gross incomeTaxable income = Gross income

- All expenditures but capital expenditures- All expenditures but capital expenditures

- Depreciation and depletion charges- Depreciation and depletion charges

Note:Note:

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

Taxable Income of Taxable Income of IndividualsIndividuals

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Classification of Business Classification of Business ExpendituresExpenditures

There are three distinct types of business expenditures:There are three distinct types of business expenditures:1. for depreciable assets (e.g., buildings);1. for depreciable assets (e.g., buildings);2. for non-depreciable assets (e.g., land, minerals);2. for non-depreciable assets (e.g., land, minerals);3. all other business expenditures (e.g., labor, materials).3. all other business expenditures (e.g., labor, materials).

Expenditures for depreciable assets.Expenditures for depreciable assets. This is the subject of the last chapter. This is the subject of the last chapter.

Expenditures for non-depreciable assetsExpenditures for non-depreciable assets. Non-depreciable assets include: . Non-depreciable assets include: land (land has no finite life); land (land has no finite life); properties properties not used not used either in a trade, business, or for the production of either in a trade, business, or for the production of

income (e.g., home, automobile). income (e.g., home, automobile). Assets subject to depletion.Assets subject to depletion.  Since firms usually acquire assets for use in the business, Since firms usually acquire assets for use in the business, their only non-depreciable assets normally are land and assets subject their only non-depreciable assets normally are land and assets subject

to depletionto depletion..

All other business expenditures.All other business expenditures. This is probably the largest category. It This is probably the largest category. It includes all the ordinary and necessary expenditures of operating a includes all the ordinary and necessary expenditures of operating a business, including the following: business, including the following: 1. labor costs; 2. materials;1. labor costs; 2. materials; 3. all direct and indirect costs;3. all direct and indirect costs;4. facilities and productive equipment with a useful life of one year or less.4. facilities and productive equipment with a useful life of one year or less.

These are all routine expenditures.These are all routine expenditures.

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Recall there are three distinct types of business expenditures:Recall there are three distinct types of business expenditures:1) for depreciable assets;1) for depreciable assets;2) for non-depreciable assets;2) for non-depreciable assets;

3) all other business expenditures. 3) all other business expenditures. 

Entering capital expenditures into the accounting records of the firm Entering capital expenditures into the accounting records of the firm is called is called capitalizingcapitalizing them.them.

Entering all other business expenditures into the accounting records Entering all other business expenditures into the accounting records is called is called expensingexpensing them. them.

Capital Expenditures

Expense Expenditures

Taxable Income of Taxable Income of IndividualsIndividuals

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Taxable Income: ExampleTaxable Income: Example

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

For SL depreciation and no salvage value, For SL depreciation and no salvage value, the annual depreciation charge is (P-S)/N = (60-0)/3 = $20 million;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.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 - 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?indication of the annual performance of the firm?

Year 1Year 1 Year 2Year 2 Year 3Year 3

Gross income from sales Gross income from sales $200$200 $200$200 $200$200

Purchase of special tooling (useful life: 3 years) Purchase of special tooling (useful life: 3 years) -$60-$60

All other expenditures All other expenditures -$140-$140 -$140-$140 -$140-$140

Cash results for the year Cash results for the year $0$0 $60$60 $60$60

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Individual Tax RatesIndividual Tax Rates

2003 US Tax Rates2003 US Tax Rates – If you are not married – If you are not married

Tax BracketsTax Brackets TaxTax

OverOver But not But not overover Base TaxBase Tax PlusPlus On Income On Income

OverOver

$0$0 $ 6,000$ 6,000 $0.00$0.00 10.0%10.0% $0$0

6,0006,000 28,40028,400 600.00600.00 15.0%15.0% 6,0006,000

28,40028,400 68,80068,800 3,960.003,960.00 27.0%27.0% 28,40028,400

68,80068,800 143,500143,500 14,868.0014,868.00 30.0%30.0% 68,80068,800

143,500143,500   311,950311,950 37,278.0037,278.00 35.0%35.0% 143,500143,500

Over 311,950Over 311,950 96,235.5096,235.50 38.6%38.6%   311,950311,950

1111

% Taxes Paid

0

5

10

15

20

25

30

35

$0

$13,

600

$26,

300

$39,

000

$51,

700

$64,

400

$77,

100

$89,

800

$102

,500

$115

,200

$127

,900

$140

,600

$153

,300

$166

,000

$178

,700

$191

,400

$204

,100

$216

,800

$229

,500

$242

,200

$254

,900

$267

,600

$280

,300

$293

,000

$305

,700

Taxable Income

%

Individual Tax RatesIndividual Tax Rates

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Individual Tax Rates: ExamplesIndividual Tax Rates: Examples

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

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

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

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

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

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

4.4. Bill is an unmarried student. He earned $8,000 in the summer, plus another $2,000 during the 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 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?he spent $1000 on allowable itemized deductions. How much income tax does he pay?

– Adjusted gross income (AGI) = $8,000 + 2,000 = $10,000. Adjusted gross income (AGI) = $8,000 + 2,000 = $10,000. – Taxable income = AGI – Deduction for one exemption - Standard deduction = Taxable income = AGI – Deduction for one exemption - Standard deduction =

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

– Federal income tax = 0.10 (2,200) = $220 Federal income tax = 0.10 (2,200) = $220

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Corporate Tax RatesCorporate Tax Rates

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

If taxable income is If taxable income is overover but not overbut not over tax istax is

of the of the amount amount

overover

00 50,00050,000 0 + 15%0 + 15% $0$0

50,00050,000 75,00075,000 7,500 + 25%7,500 + 25% 50,00050,000

75,00075,000 100,000100,000 13,750 + 34%13,750 + 34% 75,00075,000

100,000100,000 335,000335,000 22,250 + 39%22,250 + 39% 100,000100,000

335,000335,000 10 million10 million 113,900 + 34%113,900 + 34% 335,000335,000

10 million10 million 15 million15 million 3,400,000 + 35%3,400,000 + 35% 10 million10 million

15 million15 million 18,333,33318,333,333 5,159,000 + 38%5,159,000 + 38% 15 million15 million

18,333,33318,333,333 6,425,667 + 35%6,425,667 + 35% 18,333,33318,333,333Note 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: ExampleCorporate Tax Rates: ExampleExampleExample

The French Chemical Corp. was formed to make household bleach. The firm bought land for The French Chemical Corp. was formed to make household bleach. The firm bought land for $220,000$220,000, had a , had a $900,000$900,000 factory building erected, and installed factory building erected, and installed $650,000$650,000 worth of chemical and packaging equipment. The worth of chemical and packaging equipment. The plant was completed and operations begin on plant was completed and operations begin on April 1April 1stst. The gross income for the calendar year was . The gross income for the calendar year was $450,000$450,000. . Supplies and all operating expenses, excluding the capital expenditures, were Supplies and all operating expenses, excluding the capital expenditures, were $100,000$100,000. The firm will use . The firm will use MACRS depreciation.MACRS depreciation.

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

Gross Income =Gross Income = $450,000$450,000 Depreciation = Depreciation = $92,885 + $16,371$92,885 + $16,371All expenditures but capital exp. = All expenditures but capital exp. = $100,000$100,000 Taxable income = Taxable income = $450,000 - $100,000 - $109,256 = $240,744$450,000 - $100,000 - $109,256 = $240,744 ..

First-year depreciation charge.First-year depreciation charge. Chemical equipment is personal property. Chemical equipment is personal property. From the table in last chapter, it is probably in the “Seven-year, all other property” class. From the table in last chapter, it is probably in the “Seven-year, all other property” class. Thus, first-year depreciation = Thus, first-year depreciation = 14.29%14.29% of of $650,000$650,000 = = $92,885$92,885..

The building is in the The building is in the 39-year real39-year real property class. property class. Being placed in Service April 1Being placed in Service April 1stst, first-year depreciation = , first-year depreciation = 1.819%1.819% of of $900,000$900,000 = = $16,371$16,371. .

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

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Capital Gains and Losses:Capital Gains and Losses:Non-depreciated AssetsNon-depreciated Assets

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

Example.Example. a)a) Suppose you buy a stock for $1,000, keep it for two years, and sell it for $1,200.Suppose you buy a stock for $1,000, keep it for two years, and sell it for $1,200.b)b) The difference = $1200 - $1,000 = $200 is called a The difference = $1200 - $1,000 = $200 is called a capital gaincapital gain..c)c) Suppose you buy a stock for $500, keep it for two years, and sell it for $400.Suppose you buy a stock for $500, keep it for two years, and sell it for $400.d)d) The difference = $400 - $500 = -$100 is called a The difference = $400 - $500 = -$100 is called a capital losscapital loss (a negative capital gain).(a negative capital gain).

Generalization: Generalization: A firm sells or exchanges a capital asset. Entries in the firm’s accounting records reflect this change. A firm sells or exchanges a capital asset. Entries in the firm’s accounting records reflect this change.    

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

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

Tax laws for treating capital gains change over timeTax laws for treating capital gains change over time . . Currently, assets held less than six months produce Currently, assets held less than six months produce short-term gains or lossesshort-term gains or losses. . Capital assets held for more than six months produce Capital assets held for more than six months produce long-term gains or losseslong-term gains or losses. .

The current tax law sets the net capital gains tax at 20% for assets held more than 12 months The current tax law sets the net capital gains tax at 20% for assets held more than 12 months by individualsby individuals..

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Gains and Losses: Depreciated Gains and Losses: Depreciated AssetsAssets

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

Gains = Capital gains + Ordinary gains (Depreciation recapture)Gains = Capital gains + Ordinary gains (Depreciation recapture)Capital gains = Salvage value – Cost basisCapital gains = Salvage value – Cost basis

   Ordinary gains = Cost basis – Book valueOrdinary gains = Cost basis – Book value

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

Ordinary loss = Book value - Salvage value Ordinary loss = Book value - Salvage value

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

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Economic Analysis Before and After Economic Analysis Before and After TaxesTaxes

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

We also We also need to do a second analysisneed to do a second analysis, , afterafter taxes. taxes.

Example.Example. Giuliano’s Pizza plans to spend Giuliano’s Pizza plans to spend $3,000$3,000 on a used truck for the shipping and receiving on a used truck for the shipping and receiving department of its local warehouse. Estimated life = department of its local warehouse. Estimated life = 5 years5 years, Estimated savings per year = , Estimated savings per year = $800$800

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

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

YeaYearr

CF before CF before taxestaxes

SL SL DeprDepr..

Taxable IncTaxable Inc . . Tax (34%)Tax (34%)CF after CF after

taxestaxes

((aa)) ((bb)) ((cc( = )( = )aa( – )( – )bb)) ((dd- = )- = )34%(c)34%(c) ((aa( + )( + )dd))

00 --$3,000$3,000 --$3,000$3,000

11 800800 450450 350350 --119119 681681

22 800800 450450 350350 --119119 681681

33 800800 450450 350350 --119119 681681

44 800800 450450 350350 --119119 681681

55 800800 + + 750750 450450 350350 --119119 681681 + + 750750

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

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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.

ExampleA 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.)

Economic Analysis Before and After Economic Analysis Before and After TaxesTaxes

1919

YearYear CF before taxesCF before taxesSL SL

DeprDepr..Taxable IncTaxable Inc . . Tax (39%)Tax (39%) CF after taxesCF after taxes

((aa)) ((bb)) ((cc( = )( = )aa( – )( – )bb)) ((dd- = )- = )39%(c)39%(c) ((aa( + )( + )dd))

00 --$20,000$20,000 --$20,000$20,000

11 1,0001,000 00 1,0001,000 --390390 610610

22 1,5001,500 00 1,5001,500 --585585 915915

33 2,0002,000 00 2,0002,000 --780780 1,2201,220

44 2,5002,500 + + 20,00020,000 00 2,5002,500 --975975 1,5251,525 + + 20,00020,000

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.

Economic Analysis Before and After Economic Analysis Before and After TaxesTaxes