US TAX SYSTEM. # Important to Account for Impact of Taxes on Income. R we are concerned with after-tax cash flows (ATCF)

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1 US TAX SYSTEM # Important to Account for Impact of Taxes on Income R we are concerned with after-tax cash flows (ATCF) # Internal Revenue Service (IRS) R responsible for collecting taxes R regulations # Calculation of Tax Liability R gross income less adjustments to income adjusted gross income less personal exemptions and deductions taxable income times tax rate tax liability

2 Let s start to use to some notation: TL j = (R j - E j ) t where TL j = tax liability in period j R j = revenue in period j E j = expense in period j t = tax rate NIAT ATCF j = (R j - E j ) (1 - t) + NCA j where ATCF j = after-tax cash flow in period j NCA j = non-cash adjustments in period j

3 # Progressive Tax vs. Regressive Tax R Federal tax is progressive As income rises, tax rate increases R Sales tax, property tax, soc. sec. tax, state tax (?) are regressive As income rises, tax rate constant or falls # Marginal vs. Average Tax Rate R Average tax rate = tax liability taxable income R Marginal tax rate = tax rate on next $1 of taxable income. R Sometimes average tax rate = taxliability gross income R In progressive system marginal tax rate $ average tax rate

4 # Calculation of Tax Liability R 2001 Tax Schedule Married Filing Jointly Taxable Income Single Taxable Income Tax Rate (%) $0-45,200 $0-27, $45, ,250 $27,051-65, $109, ,500 $65, , $166, ,350 $136, , $297,351 + $297, First $45,200 taxed at 15% Next $64,050 taxed at 27.5% (109,250-45,200 = $64,050) R Suppose married couple had $120,000 taxable income $45,200 x.15 = $ 6, $64,050 x.275 = 17, ,750 x.305 = 3, tax liability $27,672.50

5 $27, Average tax rate = =.2306 or 23.06% $120,000 Marginal tax rate = 30.50% R If you are evaluating a new investment opportunity, which tax rate would you use? # Total Marginal Tax Rate R Total marginal tax rate > Fed marginal tax rate Federal 30.5 % State 4.2 Soc. Sec Marg. Tax Rate City 3 Self Employment 5.3 (.0765 x (1-.305) =.0532) Marg. Tax Rate %

6 O Federal Income Tax Rates for Corporations Q 2001 Tax Schedule Q Federal Income Tax Rates for Corporations in 2001 Taxable Income $0 - $50,000 50,001-75,000 75, , , , ,001-10,000,000 10,000,001-15,000,000 15,000,001-18,333,333 18,333,333 + Tax Rate 15%

7 # Bracket Creep Loss in purchasing power as inflation occurs in a progressive tax system. Suppose tax rate is t 1 I and inflation is i Initial purchasing power: I (1 - t 1 ) Purchasing power after inflation = I (1 + i)(1 - t 1 ) Real purchasing power = I(1 % i)(1 & t 1 ) (1 % i) I(1 & t 1 ) Now suppose t 1 I < I 0 t 2 I > I 0 t 2 > t 1 Purchasing power after inflation (I = I 0 ) = I (1 - t 1 ) + Ii (1 - t 2 ) Real purchasing power I(1 & t 1 ) % Ii(1 & t 2 ) (1 % i) < I(1 & t 1 ) % Ii(1 & t 1 ) (1 % i) I(1 & t 1 )

8 # Bracket Creep Inflation induced tax increase that reduces purchasing power in a progressive tax system. R Suppose single individual taxable income is $27,050 Purchasing power = $27,050(1-.15) = $22, R Suppose salary and inflation increase 10% next year. Salary = $27,050 (1+.10) = $29,755 Purchasing Power = $27,050(1-.15) + $2,705(1-.275) = 22, , = 24, Cost of goods & services = $22,992.50(1+.10) = $25, Amount needed to maintain purchasing power: $25, $24, = $ R IRS often makes periodic adjustments to tax schedules.

9 # Interest and Divided Income R Generally taxed as ordinary income. R Some exceptions - municipal bonds, IRA returns, etc. Municipal bonds - debt issued by state & local governments interest payment exempt from federal taxes. R Suppose t = 27.5%. A $1,000 corporate bond yields 10% while a $1,000 municipal bond yields 8%. Which would you invest in? Asset Before-tax CF - Taxes = ATCF corp. bond $1000(.10) = $100 $100(.275)=$27.5 $725 mun. bond $1000(0.08)= $80 0(.28)=0 $80 R Alternative: after tax = before tax (1-t) corp. bond ATCF = $100(1-.28) = $72 mun. bond ATCF = $ 80(1-.0) = $80

10 R Percentage return - standardized measure Percentage return = cash flow during period Investment at the beginning of period R After-tax returns $72.50 corp. bond: = or 7.25% $1,000 $80 mun. bond: = 0.08 or 8.0% $1,000 R Before tax = After&tax (1&t) R Suppose you want the before tax corp. bond yield that gives the same after-tax return as the municipal bond. Pre-tax equivalent yield = 0.08 = or 11.34% (1&.275) Check: $1,000 corporate bond would yield an after-tax cash flow of $110.34(1-.275) = $80

11 # Interest Paid by Individuals R Generally not deductible R Exceptions: Home mortgages and student loans. # Capital Gains and Losses R If MV - BV > 0 Capital gain = MV - BV R If BV - MV > 0 Capital loss = BV - MV R Marginal tax rates on capital gains. Months Held Tax Rate 0 < 12 Ordinary Income % a a = 10% for those with ordinary income tax rates at 15%. R Recapture rate on depreciation for commercial real estate taxed at 25%. R Capital losses used to first offset capital gains, then ordinary income.

12 Example 1: Buy land 5 years ago for $30,000 Sell land today for $50,000 Ordinary income tax rate is $35.5% Capital gain = $50,000 - $30,000 = $20,000 Tax on capital gain = $20,000 (.20) = $4,000 Example 2: Sold above land for $20,000 No other capital gains Ordinary income tax rate = 35.5% Capital loss = $30,000 - $20,000 = $10,000 Tax savings = $10,000 (.355) = $3,550 Example 3: Sold above land for $20,000 Realized $20,000 in capital gains on other assets Capital loss = $30,000 - $20,000 = $10,000 Tax savings = $10,000 (.20) = $2,000 Example 4: Sold above land for $20,000 Realized $5,000 in capital gains on other assets Ordinary income tax rate = 35.5% Capital loss = $30,000 - $20,000 = $10,000 Tax savings = $5,000 (.20) + $5,000 (.355) = $2,775

13 # Tax Credit - direct deduction in tax liability R Consider $1000 deduction vs. $1,000 tax credit Deduction: tax savings = $1000(.275) = $ 275 Credit: tax savings = $1000(1) = $1000 R Tuition, daycare, business investments or training # Business Taxation R S.P. and partnerships - taxed as ord. income R Corp. - have to use corp. tax schedule. (double tax)

14 # Depreciation R Expenditures for L.T. assets not always deductible in year of purchase. R Depreciation expense allocates cost of asset over its projected economic life. R Depreciation is a deductible expense so increases dep. exp. causes a decreases profits. R However, dep. exp. is a non cash expense. This results in tax savings because of lowered taxable income. Higher dep. exp. increases cash flow. R Placed in Service R Conventions half-year convention R Adjusted Basis = Book Value = Cost - Accumulated Depreciation Unadjusted Basis = Cost R Recovery Periods

15 Farm Property Recovery Periods Recovery Period in Yrs. Assets Gen. Dep. Sys. Alter. Dep. Sys. Agricultural structures (single purpose) Airplanes (including helicopters) 5 6 Automobiles 5 5 Calculators and copiers 5 6 Cattle (dairy or breeding) 5 7 Communication equipment 7 10 Computers and peripheral equipment 5 5 Cotton ginning assets 7 12 Drainage facilities Farm buildings Farm machinery and equipment 7 10 Fences (agricultural) 7 10 Goats and sheep (breeding) 5 5 Grain bin 7 10 Hogs (breeding) 3 3 Horses (age when placed in service) Breeding and working (12 yrs or less) Breeding and working (more than 12 yrs) Racing horses (more than 2 yrs) Horticultural structures (single purpose) Logging machinery and equipment 5 6 Nonresidential real property Office equipment (not calculators, copiers, or typewriters) 7 10 Office furniture or fixtures 7 10 Residential rental property Tractor units (over-the-road) 3 4 Trees or vines bearing fruit or nuts Truck (heavy duty, unloaded weight 13,000 lbs. or more) 5 6 Truck (weight less than 1 3,000 lbs.) 5 5 Typewriter 5 6 Water wells 15 20

16 R Straight line straight line recovery rate = 1 recovery period Dep = (unadjusted basis) x recovery rate Half-year convention Straight line percentages Year 3-Year 5-Year 7-Year % 10% 7.14%

17 R Modified Accelerated Cost Recovery System (MACRS) Dep. exp. = unadjusted basis x recovery rate MACRS Dep. Rates (150% DB method) Year 3 Year 5 Year 7 Year % 15.0% 10.71% Uses either 150% or 200% declining balance method with a switch to straight line when straight line depreciation becomes larger

18 R Suppose you purchased a $100,000 asset with a 3 yr life that fell into the 3 yr class with a half-year convention. Straight Line Year Recovery Rate Basis Depreciation Rate Accummulated Depreciation $100,000 $16,670 $16, ,000 33,330 50, ,000 33,330 88, ,000 16, ,000 MACRS (150% DB method) Yr Recovery Rate Basis Dep. Exp. Dep. Accumulated 1.25 $100,000 25,000 $ 25, $100,000 37,500 62, $100,000 25,000 87, $100,000 12, ,000 R Businesses often use S.L. for reporting profit and MACRS for tax purposes - why?

19 # Interest and Dividends Received (Bus.) R Interest - taxed as corp. income in corporations - taxed as ord. income in S.P. & partnerships R Dividends - S.P. & partnerships taxed as ord. income R Dividends to corporations allowed 80% tax exclusion. R Which is better for corp. in 34% tax bracket $1,000 interest or dividend income? Investment Income - Taxes ATCF Interest Income $1, (.34) $660 Div. Income $1, (.20)(.34) $932 Effective tax rate = $1(.20)(.34) = or 6.8% R Investment incentives?

20 # Interest & Dividends Paid (Bus.) R Dividends - not deductible R Interest - deductible R Consider firm in 34% tax bracket with $1000 interest exp vs. $1000 dividend expense. Expense - tax savings = After-tax exp. Int. exp $1000 $1000(.34) $ 660 Div. exp $ $1000 R After Tax Expense Dividends 6 $1 for $1 expense Interest 6 $1(1-.34) = $0.66 for each $1 expense R Alternative way to look at it - Before-tax expense $1.00 Dividend: = $ Takes $1.52 EBIT to pay $1 Div. (1&.34) Interest: $0.66 (1&.34) = $1.00. Takes $1 EBIT to pay $1 Int. R Tax laws favor interest financing.

21 US TAX SYSTEM # Important to Account for Impact of Taxes on Income R we are concerned with after-tax cash flows (ATCF) # Internal Revenue Service (IRS) R responsible for collecting taxes R regulations # Calculation of Tax Liability R gross income less adjustments to income adjusted gross income less personal exemptions and deductions taxable income times tax rate tax liability

22 Let s start to use to some notation: TL j = (R j - E j ) t where TL j = tax liability in period j R j = revenue in period j E j = expense in period j t = tax rate NIAT ATCF j = (R j - E j ) (1 - t) + NCA j where ATCF j = after-tax cash flow in period j NCA j = non-cash adjustments in period j

23 # Progressive Tax vs. Regressive Tax R Federal tax is progressive As income rises, tax rate increases R Sales tax, property tax, soc. sec. tax, state tax (?) are regressive As income rises, tax rate constant or falls # Marginal vs. Average Tax Rate R Average tax rate = tax liability taxable income R Marginal tax rate = tax rate on next $1 of taxable income. R Sometimes average tax rate = taxliability gross income R In progressive system marginal tax rate $ average tax rate

24 # Calculation of Tax Liability R 2001 Tax Schedule Married Filing Jointly Taxable Income Single Taxable Income Tax Rate (%) $0-45,200 $0-27, $45, ,250 $27,051-65, $109, ,500 $65, , $166, ,350 $136, , $297,351 + $297, First $45,200 taxed at 15% Next $64,050 taxed at 27.5% (109,250-45,200 = $64,050) R Suppose married couple had $120,000 taxable income $45,200 x.15 = $ 6, $64,050 x.275 = 17, ,750 x.305 = 3, tax liability $27,672.50

25 $27, Average tax rate = =.2306 or 23.06% $120,000 Marginal tax rate = 30.50% R If you are evaluating a new investment opportunity, which tax rate would you use? # Total Marginal Tax Rate R Total marginal tax rate > Fed marginal tax rate Federal 30.5 % State 4.2 Soc. Sec Marg. Tax Rate City 3 Self Employment 5.3 (.0765 x (1-.305) =.0532) Marg. Tax Rate %

26 O Federal Income Tax Rates for Corporations Q 2001 Tax Schedule Q Federal Income Tax Rates for Corporations in 2001 Taxable Income $0 - $50,000 50,001-75,000 75, , , , ,001-10,000,000 10,000,001-15,000,000 15,000,001-18,333,333 18,333,333 + Tax Rate 15%

27 # Bracket Creep Loss in purchasing power as inflation occurs in a progressive tax system. Suppose tax rate is t 1 I and inflation is i Initial purchasing power: I (1 - t 1 ) Purchasing power after inflation = I (1 + i)(1 - t 1 ) Real purchasing power = I(1 % i)(1 & t 1 ) (1 % i) I(1 & t 1 ) Now suppose t 1 I < I 0 t 2 I > I 0 t 2 > t 1 Purchasing power after inflation (I = I 0 ) = I (1 - t 1 ) + Ii (1 - t 2 ) Real purchasing power I(1 & t 1 ) % Ii(1 & t 2 ) (1 % i) < I(1 & t 1 ) % Ii(1 & t 1 ) (1 % i) I(1 & t 1 )

28 # Bracket Creep Inflation induced tax increase that reduces purchasing power in a progressive tax system. R Suppose single individual taxable income is $27,050 Purchasing power = $27,050(1-.15) = $22, R Suppose salary and inflation increase 10% next year. Salary = $27,050 (1+.10) = $29,755 Purchasing Power = $27,050(1-.15) + $2,705(1-.275) = 22, , = 24, Cost of goods & services = $22,992.50(1+.10) = $25, Amount needed to maintain purchasing power: $25, $24, = $ R IRS often makes periodic adjustments to tax schedules.

29 # Interest and Divided Income R Generally taxed as ordinary income. R Some exceptions - municipal bonds, IRA returns, etc. Municipal bonds - debt issued by state & local governments interest payment exempt from federal taxes. R Suppose t = 27.5%. A $1,000 corporate bond yields 10% while a $1,000 municipal bond yields 8%. Which would you invest in? Asset Before-tax CF - Taxes = ATCF corp. bond $1000(.10) = $100 $100(.275)=$27.5 $725 mun. bond $1000(0.08)= $80 0(.28)=0 $80 R Alternative: after tax = before tax (1-t) corp. bond ATCF = $100(1-.28) = $72 mun. bond ATCF = $ 80(1-.0) = $80

30 R Percentage return - standardized measure Percentage return = cash flow during period Investment at the beginning of period R After-tax returns $72.50 corp. bond: = or 7.25% $1,000 $80 mun. bond: = 0.08 or 8.0% $1,000 R Before tax = After&tax (1&t) R Suppose you want the before tax corp. bond yield that gives the same after-tax return as the municipal bond. Pre-tax equivalent yield = 0.08 = or 11.34% (1&.275) Check: $1,000 corporate bond would yield an after-tax cash flow of $110.34(1-.275) = $80

31 # Interest Paid by Individuals R Generally not deductible R Exceptions: Home mortgages and student loans. # Capital Gains and Losses R If MV - BV > 0 Capital gain = MV - BV R If BV - MV > 0 Capital loss = BV - MV R Marginal tax rates on capital gains. Months Held Tax Rate 0 < 12 Ordinary Income % a a = 10% for those with ordinary income tax rates at 15%. R Recapture rate on depreciation for commercial real estate taxed at 25%. R Capital losses used to first offset capital gains, then ordinary income.

32 Example 1: Buy land 5 years ago for $30,000 Sell land today for $50,000 Ordinary income tax rate is $35.5% Capital gain = $50,000 - $30,000 = $20,000 Tax on capital gain = $20,000 (.20) = $4,000 Example 2: Sold above land for $20,000 No other capital gains Ordinary income tax rate = 35.5% Capital loss = $30,000 - $20,000 = $10,000 Tax savings = $10,000 (.355) = $3,550 Example 3: Sold above land for $20,000 Realized $20,000 in capital gains on other assets Capital loss = $30,000 - $20,000 = $10,000 Tax savings = $10,000 (.20) = $2,000 Example 4: Sold above land for $20,000 Realized $5,000 in capital gains on other assets Ordinary income tax rate = 35.5% Capital loss = $30,000 - $20,000 = $10,000 Tax savings = $5,000 (.20) + $5,000 (.355) = $2,775

33 # Tax Credit - direct deduction in tax liability R Consider $1000 deduction vs. $1,000 tax credit Deduction: tax savings = $1000(.275) = $ 275 Credit: tax savings = $1000(1) = $1000 R Tuition, daycare, business investments or training # Business Taxation R S.P. and partnerships - taxed as ord. income R Corp. - have to use corp. tax schedule. (double tax)

34 # Depreciation R Expenditures for L.T. assets not always deductible in year of purchase. R Depreciation expense allocates cost of asset over its projected economic life. R Depreciation is a deductible expense so increases dep. exp. causes a decreases profits. R However, dep. exp. is a non cash expense. This results in tax savings because of lowered taxable income. Higher dep. exp. increases cash flow. R Placed in Service R Conventions half-year convention R Adjusted Basis = Book Value = Cost - Accumulated Depreciation Unadjusted Basis = Cost R Recovery Periods

35 Farm Property Recovery Periods Recovery Period in Yrs. Assets Gen. Dep. Sys. Alter. Dep. Sys. Agricultural structures (single purpose) Airplanes (including helicopters) 5 6 Automobiles 5 5 Calculators and copiers 5 6 Cattle (dairy or breeding) 5 7 Communication equipment 7 10 Computers and peripheral equipment 5 5 Cotton ginning assets 7 12 Drainage facilities Farm buildings Farm machinery and equipment 7 10 Fences (agricultural) 7 10 Goats and sheep (breeding) 5 5 Grain bin 7 10 Hogs (breeding) 3 3 Horses (age when placed in service) Breeding and working (12 yrs or less) Breeding and working (more than 12 yrs) Racing horses (more than 2 yrs) Horticultural structures (single purpose) Logging machinery and equipment 5 6 Nonresidential real property Office equipment (not calculators, copiers, or typewriters) 7 10 Office furniture or fixtures 7 10 Residential rental property Tractor units (over-the-road) 3 4 Trees or vines bearing fruit or nuts Truck (heavy duty, unloaded weight 13,000 lbs. or more) 5 6 Truck (weight less than 1 3,000 lbs.) 5 5 Typewriter 5 6 Water wells 15 20

36 R Straight line straight line recovery rate = 1 recovery period Dep = (unadjusted basis) x recovery rate Half-year convention Straight line percentages Year 3-Year 5-Year 7-Year % 10% 7.14%

37 R Modified Accelerated Cost Recovery System (MACRS) Dep. exp. = unadjusted basis x recovery rate MACRS Dep. Rates (150% DB method) Year 3 Year 5 Year 7 Year % 15.0% 10.71% Uses either 150% or 200% declining balance method with a switch to straight line when straight line depreciation becomes larger

38 R Suppose you purchased a $100,000 asset with a 3 yr life that fell into the 3 yr class with a half-year convention. Straight Line Year Recovery Rate Basis Depreciation Rate Accummulated Depreciation $100,000 $16,670 $16, ,000 33,330 50, ,000 33,330 88, ,000 16, ,000 MACRS (150% DB method) Yr Recovery Rate Basis Dep. Exp. Dep. Accumulated 1.25 $100,000 25,000 $ 25, $100,000 37,500 62, $100,000 25,000 87, $100,000 12, ,000 R Businesses often use S.L. for reporting profit and MACRS for tax purposes - why?

39 # Interest and Dividends Received (Bus.) R Interest - taxed as corp. income in corporations - taxed as ord. income in S.P. & partnerships R Dividends - S.P. & partnerships taxed as ord. income R Dividends to corporations allowed 80% tax exclusion. R Which is better for corp. in 34% tax bracket $1,000 interest or dividend income? Investment Income - Taxes ATCF Interest Income $1, (.34) $660 Div. Income $1, (.20)(.34) $932 Effective tax rate = $1(.20)(.34) = or 6.8% R Investment incentives?

40 # Interest & Dividends Paid (Bus.) R Dividends - not deductible R Interest - deductible R Consider firm in 34% tax bracket with $1000 interest exp vs. $1000 dividend expense. Expense - tax savings = After-tax exp. Int. exp $1000 $1000(.34) $ 660 Div. exp $ $1000 R After Tax Expense Dividends 6 $1 for $1 expense Interest 6 $1(1-.34) = $0.66 for each $1 expense R Alternative way to look at it - Before-tax expense $1.00 Dividend: = $ Takes $1.52 EBIT to pay $1 Div. (1&.34) Interest: $0.66 (1&.34) = $1.00. Takes $1 EBIT to pay $1 Int. R Tax laws favor interest financing.

Depreciation i for tax purposes is not the same as depreciation for management decisions or

Depreciation i for tax purposes is not the same as depreciation for management decisions or accounting. Non cash event but still reduces taxable income Flexibility in calculating it Can be used to level