Introduction. 15: Taxes on Ordinary Income for Projects. Introduction Types of Taxpayers and Taxable Income. Types of Taxpayers

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Introduction 15: Taxes on Ordinary Income for Projects Major cash flow, so cannot be ignored Tax regulations interpret tax code (1.3M words) Fund government and implement social, economic, and political objectives Complex product of 1,000s of compromises designed for very wide range of taxpayers Following are basic rules, but almost always exceptions Get qualified help before committing resources CPAs and tax attorneys, texts, IRS publications, web sites Introduction 15.1 Types of Taxpayers and Taxable Income Must know who pays based on what income Classifications affect taxation Types of Taxpayers Two major types: individuals and corporations Others include sole proprietorships, partnerships, estates, trusts, and subchapter S corporations Flow-through entities: sole proprietorships, partnerships, subchapter S corporations do not pay taxes Have business income or loss reported by individual taxpayers who ultimately pay tax Subchapter S has some benefits of both corporations and individuals Two Major Categories of Income Can have different tax rates and regulations Ordinary income Net profits from sales, services, Sometimes sales of project equipment Capital gains and losses or loss when capital assets sold Most frequently stocks, bonds, Sometimes project equipment Need to understand regulations about disposals of project equipment

s and es on Disposals Taxable income (TI) on which taxes paid is not simple matter of summing cash flows Requires a knowledge of depreciation, disposals of assets, and other concepts Can be referred to by different names depending on type of taxpayer or loss on disposal (GLD) equals amount realized (AR) from sale after costs of selling minus the book value at time of disposal (BVd ) GLD = AR BVd on disposal (GD) if positive, else loss on disposal (LD) Example 15.1 Computing GLDs Sales price of $1,200 w/ removal costs of $400 AR = 800 = 1,200 400 If BVd equals $500, then a GD of $300 occurs: GLD = 300 = 800 500 If BVd equals $900, then a LD of $100 occurs: GLD = -100 = 800 900 Removal cost > Sales price AR < $0 LD since BVd $0 Ordinary Income Revenues: sales, charges for services, rentals, and so forth This chapter refers to ordinary income (OI) as all project revenues minus expenses, excluding GLDs Since TI includes everything on which taxes paid, then TI = OI GLDs GLDs usually relatively small component See shortly when may treat GLDs as OI and when more complex capital gains rules apply Expenses Expenses: anything subtracted from revenues to determine OI For purposes of project economics: Expenses = Operating costs + Depr + Depl + Sec 179 + Interest Operating costs include everything but depreciation, depletion, Section 179, and interest Examples: labor, power, rent, supplies, etc. IC not expense, but depreciation charges are Deduct interest on company car but not on personal car Treating GLDs as OI Treat GLDs of depreciated project assets as OI under certain conditions Economic analyses more complex otherwise Understanding conditions begins with classifying assets Section assets include most project equipment that is depreciated Section 1245 includes primarily MACRS personal property Section 1250 includes primarily MACRS real property Disposing a Section 1245 Property Effects of different ARs BV 0 BV d = AR - BV 0 Recapture = BV 0 - BV d Recapture = AR - BV d = BV d - AR Recapture if accelerated depr used and now BVd is smaller than AR Extra depr reduced OI too much Treat excess as OI to recapture lost taxes gain is unlikely, but can be capital gain

No accelerated depreciation for real property under MACRS enacted in 1986 No recapture if put into service after 1986 BV d Disposing a Section 1250 Property = AR BV d = BV d AR Earlier service dates can have accelerated depreciation and recapture (appendix) gain more likely than before, but industrial buildings do not appreciate like homes Probably more losses from 1245 assets Tax Effect of Disposals Recaptures: treat as OI without any further consideration For Section losses and gains during tax yr Net = If net Section loss, deduct it from OI If net Section gain, treat as capital gain (next chapter) Capital gains can affect tax rates and timing of cash flows for taxes Net gain does not seem likely Chapter assumes GLDs increase & decrease OI Example 15.2 Classifying Project GLDs ($1,000s) # Sec BV0 BVd AR Recap 1 1245 70 40 15 0 25 0 2 1245 50 20 30 10 0 0 3 1245 30 10 35 20 0 5 4 1250 90 60 50 0 10 0 5 1250 80 35 40 0 0 5 6 1250 40 30 45 0 0 15 35 25 Recapture always increases OI -10 $10 net Section loss deducted from OI # Sec BV0 BVd AR Recap 1 1245 70 40 15 0 25 0 BV 0 = 70 BV d = 40 Example 15.2 Project 1 AR = 15 = 25 = 40-15 Each gain or loss increases or decreases net deduction and hence OI Example 15.2 Project 2 Example 15.2 Project 3 # Sec BV0 BVd AR Recap 2 1245 50 20 30 10 0 0 # Sec BV0 BVd AR Recap 3 1245 30 10 35 20 0 5 BV 0 = 50 BV d = 20 AR = 30 Recapture = 10 = 30-20 BV 0 = 30 BV d = 10 AR = 35 = 5 = 35-30 Recapture = 20 = 30-10

Example 15.2 Project 4 # Sec BV0 BVd AR Recap 4 1250 90 60 50 0 10 0 Example 15.2 Project 5 # Sec BV0 BVd AR Recap 5 1250 80 35 40 0 0 5 BV d = 60 AR = 50 = 10 = 60 50 BV d = 35 AR = 40 = 5 = 40 35 Example 15.2 Project 6 # Sec BV0 BVd AR Recap 6 1250 40 30 45 0 0 15 BV d = 30 AR = 45 = 15 = 45 30 15.2 Taxes on Ordinary Income for Individuals BV0 is considered only for pre-1986 purposes for Section 1250 properties Covered in Appendix Basics Overview of Computing TI Three basic steps 1. Determine TI, a five step process (next) 2. Select tax bracket 3. Compute tax 1 2 AGI = GI Adjustments TI = AGI 3 max (Standard, Itemized) Deductions Exemptions 4 5

1. Calculate gross income (GI): GI = Salary, wages, tips + Interest, dividend, royalty, & rental income + Unemployment compensation + Social security (under certain conditions) Business income or losses GLDs Determine TI Step 1 + Other income Flow through Determine TI Step 2 2. Subtract adjustments from GI to obtain adjusted gross income (AGI) Adjustments include interest on student loans, payments into qualified retirement plans, cafeteria plans, and alimony AGI = GI Adjustments Persons with high AGIs must decrease some of the following deductions Determine TI Step 3 3. max (Standard, Itemized) Deductions Standard for 2011 $5,450 (single) $10,900 (married couples filing jointly) Determine TI Step 4 4. Exemption of $3,500 in 2011 for each dependent to recognize costs of support Include an exemption for the taxpayer! Itemized deductions include: a) medical and dental expenses > 7½% AGI b) non-federal income and property taxes c) home mortgage interest, limited investment interest d) qualified charitable contributions e) casualty and theft losses up to limits f) miscellaneous deductions Determine TI Step 5 2011 Individual Tax Schedule 5. Evaluate taxable income as: TI = AGI max (Standard, Itemized) Deduction Exemptions Bracket Tax 0 OI 8,500 10% OI 8,500 < OI 34,500 850.00 + 15% (OI 8,500) 34,500 < OI 83,600 4,750.00 + 25% (OI 34,500) 83,600 < OI 174,400 17,025.00 + 28% (OI 83,600) 174,400 < OI 379,150 42,449.00 + 33% (OI 174,400) 379,150 < OI 110,016.50 + 35% (OI 379,150)

2011 Married Tax Schedule (Filing Jointly) Bracket 0 OI 17,000 10% OI Tax 17,000 < OI 69,000 1,700.00 + 15% (OI 17,000) 69,000 < OI 139,350 9,500.00 + 25% (OI 69,000) 139,350 < OI 212,300 27,087.50 + 28% (OI 139,350) 212,300 < OI 379,150 47,513.50 + 33% (OI 212,300) 379,150 < OI 102,574.00 + 35% (OI 379,150) Observations Tax schedules are progressive Rate increases as OI increases Flat tax uses only one rate Bracket amounts equal sum of taxes paid in previous bracket, so if enter a higher bracket only the TI in that bracket is taxed at its rate Fixed cost component equals taxes up to beginning of bracket Example 15.3 Marriage Tax Jack Jack and Jill to commit matrimony Jack has AGI of $43,550 (all OI), $1,800 of itemized deductions, and no GLDs No GLDs all TI is OI OI = 43,550 max(1,800, 5,450) 3,500 = $34,600 Bracket Tax 34,500 < OI 83,600 4,750 + 25% (OI 34,500) Tax = 4,750 + 0.25(34,600 34,500) = $4,775 Example 15.3 Marriage Tax Jill Jill has AGI of $48,550 (all OI), $2,600 of itemized deductions, before considering one GLD, a Section loss of $1,000 One GLD net Sec loss = $1,000 OI AGI = $47,550 = 48,550 1,000 OI = 47,550 max(2,600, 5,450) 3,500 = $38,600 Bracket Tax 34,500 < OI 83,600 4,750 + 25% (OI 34,500) Tax = 4,750 + 0.25(38,600 34,500) = $5,775 Example 15.3 Marriage Tax Married Example 15.3 Marriage Tax Family Values Combined AGI and itemized deductions are sums of individual ones AGI = 87,200 = 41,600 + 45,600 OI = 87,200 max(4,400, 10,900) 3,500(2) Bracket = $69,300 Tax = 8,963 + 0.25(69,300 65,100) = $10,013 Tax 65,100 < OI 131,450 8,962.50 + 25% (OI 65,100) Total tax as singles who live together $10,013 = 4,506 + 5,506 Tax as married filing jointly $10,013 Marriage penalty Special for lower income only! $0 = 10,013 10,013 Couples with higher incomes pay more if married than if single and living together, as shown in homework Historically, marrieds have paid more than two singles the marriage penalty

Yes, Dear! Happily married for a year now Wed sometime last century The extra tax is worth every penny! 15.3 Taxes for Corporations Basics Only individuals have adjustments, exemptions, and standardized or itemized deductions OI = Revenues Expenses, TI = OI GLDs excluding GLDs If corporation has net Section losses, can treat each project's GLD as OI If corporation has net Section gains, little or no error by treating each project's GLD as OI Reasonable approach for corporations Not case for individuals Details in next chapter Corporate Tax Schedule Between 0 50,000 75,000 100,000 335,000 10,000,000 15,000,000 18,333,333 Pay Plus 0 15% 7,500 25% 13,750 34% 22,250 39% 113,900 34% 3,400,000 35% 5,150,000 38% 6,416,667 35% Irregular progression due to compromises Some bracket increases delayed and then made up with surcharges Ex 15.4 Corporate Income Taxes Without GLDs Revenues and expenses are: Revenues = $114,000 Operating costs = $25,000 Depreciation charges = $10,000 Section 179 expense = $4,000 Interest = $3,000 TI = 114,000 25,000 10,000 4,000 3,000 = $72,000 Between 50,000 75,000 Pay Plus 7,500 25% Tax = $13,000 = 7,500 + (0.25)(72,000 50,000) Ex 15.5 Corporate Income Taxes with GLDs Prior to a Section disposal, preceding corporation has OI = $72,000 Income tax = $13,000 Tax bracket = 25% Disposal BV0 = $30,000 Depr plus Sec 179 total to $20,000 BVd = $10,000 = 30,000 20,000

Ex 15.5 w/ BVd = $10,000 and AR = $11,000 GD = $1,000 = 11,000 10,000 Reduce net Section loss by $1,000 Less loss higher revenue more OI $1,000 more OI Increase OI from $72,000 to $73,000 Increase taxes $250 = 1,000 25% From $13,000 to $13,250 Ex 15.5 w/ BVd = $10,000 and AR = $10,000 AR = $10,000 GLD = $0 = 10,000 10,000 No change in taxes Ex 15.5 w/ BVd = $10,000 and AR = $9,000 LD = $1,000 = 10,000 9,000 Increase net Section loss by $1,000 More loss less revenue less OI $1,000 less OI Decrease OI from $72,000 to $71,000 Decrease taxes $250 = 1,000 25% From $13,000 to $12,750 Ex 15.5 w/ BVd = $10,000 and Compute AR Sell for $1,000 w/ removal costs of $3,000 AR = -$2,000 = 1,000 3,000 LD = $12,000 = 10,000 (-2,000) Increase net Section loss by $12,000 More loss less revenue less OI $12,000 less OI Decrease OI from $72,000 to $60,000 Decrease taxes $3,000 = 12,000 25% From $13,000 to $10,000 Topic 15.4 Marginal and Combined Tax Rates How to determine the tax rates to use in an economic analysis

Marginal Tax Rates Corporations's TI is $90,000 Bracket: 75,000 < TI 100,000 Tax = 13,750 + 34% (TI 75,000) New project increases TI by $8,000 Taxed at 34% rate Tax paid on project = $2,720 = (0.34)8,000 New project decreases TI by $8,000 Taxed at 34% rate Tax saved by project = $2,720 = (0.34)8,000 34% is referred to as the marginal rate Rate at which changes occur Average Rates Note that the average rate is NOT used Average rate = Taxes / TI With TI of $90,000 Taxes = 13,750 + 34% (90,000 75,000) = $18,850 Average rate = 20.9% = 18,850 / 90,000 Economic analyses always use rates at which changes occur Cost of electric power depends on use level Higher use Lower $ / KWHr Use cost in current rate block, not average Example 15.6 Use of Marginal Rates Project increases TI by $15,000 From $90,000 to $105,000 Initially in 34% bracket Project increases TI into 39% bracket 100,000 < TI 335,000 Extra tax 34% on first $10,000 up to $100,000 39% on next $5,000 after $100,000 Extra tax = (0.34)10,000 + (0.39)5,000 = $5,350 Same result if Extra Tax = Tax @ $105,000 Tax @ $90,000 Combining State and Federal Rates Deduct state from federal income taxes Consider states where the fed tax not deductible from the state tax, the most common case Suppose state and fed marginal rates are TRS = 10% and TRF = 34% State taxes consume 10% of TI Remaining 90% = 1 0.1 subject to fed tax Fed taxes are 34% of (1 0.1)TI Total taxes are [0.10 + (0.34)(1 0.10)] TI In general, Combined marginal rate = TRS + TRF(1 TRS) Mutually Deductible Few states where the fed income tax is deductible from the income state tax Appendix shows two simultaneous equations used to obtain Combined marginal rate = (TRS + TRF 2 TRS TR F) / (1 TRS TR F) 15.5 After-Tax Economic Analysis Let TRS = 10%, TRF = 34%, and fed tax is Not deductible 40.60% = 0.10 + (0.34)(1 0.1) Deductible 38.51% = [0.10 + 0.34 2(0.10)(0.34)] / [1 0.10(0.34)]

Basics Use marginal and combined income tax rates to compute cash flows for taxes After Tax Cash Flows (ATCF) ATCF = BTCF Tax Payments + Tax Savings Example 15.7 After-Tax Cash Flows Corporate special tooling with 3 year MACRS life IC = $100,000 AR = $8,000 after 3 years Yearly revenues = $43,500 State and fed marginal rates are 5% and 34% State not deductible from fed Com. Marg. Rate = 0.05 + 0.34(1 0.05) Determine ATCF = 37.3% 43,500 8,000 0 1 2 3 100,000 Example 15.7 Depreciation and BV d j r j 1 33.33 2 44.45 3 14.81 BV 0 = 100,000 4 7.41 D 1 = 33,330 = 0.3333(100,000) D 2 = 44,450 = 0.4445(100,000) D 3 = 7,405= 0.1481(100,000) / 2 BV 3 = 100,000 33,330 44,450 7,405 = 14,815 Example 15.7 ATCF Table (Rounded to Fit) Yr BTCF Dep / BV TI Taxes ATCF 0-100,000-100,000 1 43,500 33,330 10,170 3,793 39,707 2 43,500 44,450-950 -354 43,854 3 43,500 7,405 36,095 13,463 30,037 3 8,000 14,815-6,815-2,542 10,542 1st: OI 2nd: Disposal - Show GLD - Different Rate IC unless credit BVd = BV0 Dj TI = BTCF Depr Taxes = TI x Rate ATCF = BTCF Taxes Ex 15.7 Other Disposal Scenarios (Rounded) AR = $14,815 GLD = $0, so Tax = $0 and ATCF = BTCF Yr BTCF Dep / BV TI Taxes ATCF -- --- --- --- --- --- 3 14,815 14,815 0 0 14,815 -- --- --- --- --- --- 3 15,815 14,815 1,000 373 15,442 AR = $15,815 GD = $1,000 = 15,815 14,815 Tax payment = $373 = 1,000(0.373) ATCF = $15,442 = 15,815 373 Evaluation of Economic Criteria Just as calculate BTIRR from BTCF, must compute ATIRR from the ATCF Approximation: ATIRR (1 TRS+F) BTIRR BTIRR = 20% and TRS+F = 35% 13% (1 0.35)20% All effects of depr and GLDs not considered In general, for surrogate criteria the discount rate equals the average IRR of marginal projects Compare BT projects w/ BT AMRR Done only if obvious differences among alts Compare AT projects w/ AT AMRR

Ex 15.9 BT and AT Analyses IRRs Previous project Flows on right BTIRR of 17.67% and ATIRR of 11.59% are computed from: Year BTCF ATCF 0-100,000-100,000.00 1 43,500 39,706.59 2 43,500 43,854.35 3 43,500 30,036.56 3 8,000 10,542.00 Ex 15.9 BT and AT Analyses Approximate IRR Notice the approximate nature of relationship ATIRR (1 TRS+F) BTIRR 11.59% 11.08% = (1 0.373)17.67 Quality of approximation can vary BT: 0 = -100,000 + 43,500(P A, i, 2-0) + (43,500 + 8,000)(P F, i, 3-0) AT: 0 = -100,000 + 39,706.59(P F, i, 1) + 43,854.35(P F, i, 2) + (30,036.56 + 10,542.00)(P F, i, 3) Ex 15.9 BT and AT Analyses PW Marginal projects average 18% BT and 11% AT AMRRs determine the discount rate BT PW uses BT AMRR of 18% -$550.08 = -100,000 + 43,500(P A, 18%, 3-0) + 8,000(P F, 18%, 3-0) AT PW uses AT AMRR of 11% $1,035.57 = -100,000 + 39,702.59(P F, 11%, 1) + 43,854.35(P F, 11%, 2) + (30,036.56 + 10,542.00)(P F, 11%, 3) Project acceptable only if all cash flows are considered, including taxes Ex 15.9 BT and AT Analyses BT or AT? Taxes very real cash flows, so use after-tax analysis Use before-tax studies only if differences among alternatives large or tax flows are expected to be similar