Chapter Outline

 Individual income taxes  Corporate income taxes  Income tax rates at federal and state levels  Capital gains and losses for non-depreciated assets  After-tax cash flows and after-tax rate of return  Spreadsheets and after-tax cash flows ENG3615-Engineering Economics 2

Learning Objectives

 Taxes and tax tables  Calculate taxes for both individuals and corporations  Determine the combined income tax rates and marginal income tax rates  Develop after-tax cash flows for a project  Evaluate an investment on an after-tax basis including asset disposal  Use spreadsheet in solving after-tax economic analysis problems ENG3615-Engineering Economics 3

Vignette: On with the Wind

  Technology for renewable energy has been available for many years.

Transition to greater use of wind power requires a significant investment.

• • Federal tax law in the Energy Policy Act of 1992 allowed utilities a “production tax credit” of 1.5¢ per kWh.

With the tax credit and the advances in technology, many wind plants can now produce power for less 5¢ per kWh.

ENG3615-Engineering Economics 4

Vignette: On with the Wind

• • • • Should government support wind energy through tax credit? What are the costs and benefits of wind technology from the perspectives of the producers, consumers, and society in general. Are there any ethical issues?

What is the effect on wind energy investment if the wind power production tax credit is allowed to expire, or is extended for only a few years?

Using internet, can you determine how tax rates changed throughout the course of the 20 industry?

th century? How has this affected the value of tax credits to ENG3615-Engineering Economics 5

Income Taxes

 An give an overview of federal income taxes.  Taxes are very complex. Lifetime task  No realistic economic analysis can ignore taxes.

 Tax laws change regularly. E.g. Table 12-1, 2007 Tax Rates for individuals, does not apply for 2010.

 Sources of information on taxes include:  http://www.irs.gov

 “Your Federal Income Taxes”, free from IRS by mail  TurboTax (PC software for doing individual taxes)  Individuals and corporations pay taxes. ENG3615-Engineering Economics 6

A Partner in the Business

 U.S. Government is a partner in every business activity  Government shares profits through income taxes  Government shares losses through income taxes Related Point of View: Think of taxes as materials, etc.)

one more disbursement

(like operating costs, maintenance, labor and ENG3615-Engineering Economics 7

Taxable Income of Individuals

+ Wages, salary, etc Interest Income Dividends Capital Gains Unemployment Compensation Other Income

Gross Income

-

Gross Income

Retirement Contribution Other Adjustments

Adjusted Gross Income (AGI)

Personal Exemption(s) Itemized or Std. Deduction

Taxable Income

ENG3615-Engineering Economics 8

Taxable Income of Individuals (

2007

)

Personal Exemption:

• One exemption per dependent ($3400 for 2007 returns )

Itemized Deduction:

• Medical and dental expenses (exceeding 7.5% of AGI) • State and local income, real estate, and personal property tax • Home mortgage interest • Charitable contributions • Casualty and theft losses (exceeding $100 + 10% of AGI) • Job expenses and certain miscellaneous deductions (some categories must exceed 2% of AGI)

Standard Deduction:

• Single taxpayers, $5,350 for 2007 returns • Married taxpayers filing jointly, $10,700 for 2007 returns ENG3615-Engineering Economics 9

Taxable Income of Individuals (

2009

)

Personal Exemption:

• One exemption per dependent ($3650 for 2009 returns )

Itemized Deduction:

• Medical and dental expenses (exceeding 7.5% of AGI) • State and local income, real estate, and personal property tax • Home mortgage interest • Charitable contributions • Casualty and theft losses (exceeding $100 + 10% of AGI) • Job expenses and certain miscellaneous deductions (some categories must exceed 2% of AGI)

Standard Deduction:

• Single taxpayers, $5,700 for 2009 returns • Married taxpayers filing jointly, $11,400 for 2009 returns ENG3615-Engineering Economics 10

Classification of Business Expenditures

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

 Expenditures for depreciable assets. See Chapter 11.

ENG3615-Engineering Economics 11

Classification of Business Expenditures

 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.

ENG3615-Engineering Economics 12

Classification of Business Expenditures

 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.

2.

3.

4.

labor costs; materials; all direct and indirect costs; facilities and productive equipment with a useful life of one year or less .

 These are all routine expenditures.

ENG3615-Engineering Economics 13

Classification of Business Expenditures

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

Capital Expenditures

 all other business expenditures.

Expense Expenditures

 Entering capital expenditures into the accounting records of the firm (the “books”) is called capitalizing them.

 Entering all other business expenditures into the accounting records is called expensing them. ENG3615-Engineering Economics 14

Example 12-1 Taxable Income

 Example: A firm has the following results (in millions of dollars) for a 3-year period. Compute the taxable income for each of the 3 years.

Gross income from sales Purchase of special tooling (useful life: 3 years) All other expenditures Cash results for the year Year 1 $200 -$60 -$140 $0 Year 2 $200 -$140 $60 Year 3 $200 -$140 $60  Since the special tooling has a 3-year useful life, it is a capital expenditure.

15 ENG3615-Engineering Economics

Example 12-1 Taxable Income

Gross income from sales Purchase of special tooling (useful life: 3 years) All other expenditures Cash results for the year Year 1 $200 -$60 Year 2 $200 Year 3 $200 -$140 $0 -$140 $60 -$140 $60 Since the special tooling has a 3-year useful life, it is a capital expenditure.

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.

16 ENG3615-Engineering Economics

Example 12-1 Taxable Income

Actual cash flows: Gross income Purchase of special tooling All other expenditures Cash flows for the year Year 1 $200 -60 -140 $0 Year 2 $200 0 -140 $60 Taxable Income: Gross income All other expenditures Depreciation charges Cash flows for the year Year 1 $200 -140 -20 $40 Year 2 $200 -140 -20 $40 ENG3615-Engineering Economics Year 3 $200 0 -140 $60 Year 3 $200 -140 -20 $40 17

Maximum Federal Income Tax Rates for Individuals

100 90 80 70 60 50 40 30 20 10 0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Year

ENG3615-Engineering Economics 18

2007 Individual Tax rates

Tax Rate 10% 15% 25% 28% 33% 35% Single $0 Married/Joint Married/Separate $0 $0 Head of Household $0 $7,825 $15,650 $7,825 $11,200 $31,850 $77,100 $160,850 $349,700 $63,700 $128,500 $195,850 $349,700 $31,850 $64,250 $97,925 $174,850 $42,650 $110,100 $178,350 $349,700 ENG3615-Engineering Economics 19

2007 Federal Income Tax Rates for Individuals

Single Taxpayers Taxable Income Tax Over $0 7,825 31,850 But Not Over 7,825 31,850 77,100 77,100 160,850 160,850 349,700 Over 349,700 Base Tax ENG3615-Engineering Economics $0.00

782.50

4,386.50

15,698.75

39,148.75

101,469.25

Plus 10% 15% 25% 28% 33% 35% On Income Over $0 7,825 31,850 77,100 160,850 349,700 20

2007 Federal Income Tax Rates for Individuals

Married Individuals Filing Jointly Taxable Income Tax Over $0 15,650 63,700 But Not Over $15,650 63,700 128,500 128,500 195,850 195,850 349,700 Over 349,700 Base Tax ENG3615-Engineering Economics $0.00

1,565.00

8,772.50

24,972.50

43,830.50

94,601.00

Plus 10% 15% 25% 28% 33% 35% On Income Over $0 15,650 63,700 128,500 195,850 349,700 21

2009 Individual Tax rates

Tax Rate 10% Single $0 Married/Joint Married/Separate Head of Household $0 $0 $0 15% $8,350 $16,700 $8,350 $11,950 25% 28% 33% 35% $33,950 $82,250 $171,550 $372,950 $67,900 $137,050 $208,850 $372,950 $33,950 $68,525 $104,425 $186,475 $45,500 $117,450 $190,200 $372,950 ENG3615-Engineering Economics 22

2009 Federal Income Tax Rates for Individuals

Married Individuals Filing Jointly Taxable Income Tax Over $0 16,700 67,900 But Not Over $16,700 67,900 137,050 137,050 208,850 208,850 372,950 Over 372,950 Base Tax ENG3615-Engineering Economics $0.00

1,670.00

9,350.00

26,637.50

46,741.50

100,894.50

Plus 10% 15% 25% 28% 33% 35% On Income Over $0 16,700 67,900 137,050 208,850 372,950 23

2011 Individual Tax rates

Tax Rate 10% 15% 25% 28% 33% 35% Single $0 Married/Joint Married/Separate Head of Household $0 $0 $0 $8,500 $34,500 $17,000 $69,000 $8,500 $34,500 $12,150 $46,250 $83,600 $174,400 $379,150 $139,350 $212,300 $379,150 $69,675 $106,150 $189,575 $119,400 $193,350 $379,150 ENG3615-Engineering Economics 24

Example 12-2 - Taxable Income of Individuals

An unmarried student earned $10,000 in the summer plus another $6000 during the rest of allowable itemized deductions. 2007 . He is allowed one exemption and he spent $1000 on Gross Income = Adjusted Gross Income (AGI) = $10,000+6000 = $16,000 $1000 (itemized deductions) < $5350 (standard deduc) Taxable Income = AGI - Exemption – Standard Deduction = $16,000 – 3,400 – 5,350 = $7,250 Tax = 10%(7,250) = $725 25 ENG3615-Engineering Economics

Problem 12-4 Taxable Income of Individuals

A married couple filing jointly had a combined total adjusted gross income (AGI) of $75,000, and allowable itemized deductions of $4,000 in 2009. Compute their 2009 federal income tax.

Solution $4000 (itemized deductions) < $11400 (standard deduc) Taxable Income = AGI - Exemption – Standard Deduction = $75,000 – 2(3,650) –11,400 = $56,300 Tax = 10%(16,700) + 15%(56,300 – 16,700) = $7,610 26 ENG3615-Engineering Economics

Federal Corporate Income Tax Rates

Tax Year 2010 2009 2008 2007 2006 2005 2004 and 2003 Federal United States (USA) Corporate Tax Rates

Personal service corporations pay a flat rate of 35%

Taxable income over But not over Your tax is Of the amount over $0 $50,000 $75,000 $100,000 $335,000 $10,000,000 $15,000,000 $18,333,333 $50,000 $75,000 $100,000 $335,000 $10,000,000 $15,000,000 $18,333,333 7,500 + 13,750 + 22,250 + 113,900 + 3,400,000 + 15% 25% 34% 39% 34% 35% 5,150,000 + flat rate 35% 38% $0 $50,000 $75,000 $100,000 $335,000 $10,000,000 $15,000,000

ENG3615-Engineering Economics 27

2007

Federal Corporate Income Tax Rates

Taxable Income Not over $50,000 $50,000-75,000 $75,000-100,000 $100,000-335,000 $335,000-10 million $10 million-15 million $15 million - 18,333,333 over $18,333,333 Tax Rate 15% 25% 34% 39% 34% 35% 38% 35% Corporate Income Tax 15% over 0 7,500 + 25% over 50,000 13,750 + 34% over 75,000 22,250 + 39% over 100,000 113,900 + 34% over 335,000 3,400,000 + 35% over 10 mil.

5,150,000 + 38% over 15 mil.

6,416,667 + 35% over 18,333,333 28 ENG3615-Engineering Economics

Example 12-3 Federal Corporate Income Tax

The French Chemical Corp. bought land for $220,000, built a $900,000 factory building, and installed $650,000 worth of chemical equipment. The plant was completed and operation begun on April 1. Gross income for the calendar year was $450,000. All expenses amounted to $100,000. The firm used MACRS for depreciation. Chemical Equipment d 1 Building d 1 = $650000(14.29%) = = $900,000(1.819%) = Total first year depreciation = $92,885 $16,371 $109,256 Taxable Income = Gross Income – Expenditures – Depr.

= $450,000 – 100,000 – 109,256 = $240,744 Federal Income Tax = $22,250+39%(240,744-100,000) = $77,140 ENG3615-Engineering Economics 29

Table 11-3 MACRS GDS Percentage Rate

Recovery Year

1 2 3 4 5 6 7 8 9 10 11 12-15 16 17-20 21

3-Year Class

33.33

44.45

14.81* 7.41

5-Year Class

20.00

32.00

19.20

11.52* 11.52

5.76

7-Year Class

14.29

24.49

17.49

12.49

8.93* 8.92

8.93

4.46

10-Year Class

10.00

18.00

14.40

11.52

9.22

7.37

6.55* 6.55

6.56

6.55

3.28

15-Year Class

5.00

9.50

8.55

7.70

6.93

6.23

5.90* 5.90

5.91

5.90

5.91

5.90

2.95

20-Year Class

3.750

7.219

6.677

6.177

5.713

5.285

4.888

4.522

4.462* 4.461

4.462

4.461

4.461

4.462

2.231

ENG3615-Engineering Economics 30

Table 11-4 MACRS GDS Percentage Rate

Residential Rental Property Recovery Year 1 2-27 28 29 1 2 3 4 Month Placed in Service 5 6 7 8 9 10 11 12

3.485 3.182 2.879 2.576 2.273 1.970 1.667 1.364 1.061 0.758 0.455 0.152

3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636

1.970 2.273 2.576 2.879 3.182 3.485 3.636 3.636 3.636 3.636 3.636 3.636

0.152 0.455 0.758 1.061 1.364 1.667

Nonresidential Real Property Recovery Year 1 2-39 40 Month Placed in Service 1 2 3 4 5 6 7 8 9 10 11 12

2.461 2.247 2.033 1.819 1.605 1.391 1.177 0.963 0.749 0.535 0.321 0.107

2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564

0.107 0.321 0.535 0.749 0.963 1.177 1.391 1.605 1.819 2.033 2.247 2.461

31 ENG3615-Engineering Economics

0 1 2 3 4 5 5

Example 12-5 Before-tax and After-tax Cash Flows

Initial Cost = $3000; Annual net saving= $800; Assume 34% incr. tax rate Useful life = 5 years; Salvage value = $750; Year (a) Before-tax Cash Flow -$3000 800 800 800 800 800 750 IRR BT =15.7% (b) Straight-Line Depreciation $450 450 450 450 450 (B-S)/N= (3000-750)/5 = 450 (c)=(a)-(b)  (Taxable Income) $350 350 350 350 350 (d) Income Tax (34%) $119 119 119 119 119 (e)=(a)-(d) After-tax Cash Flow -$3000 681 681 681 681 681 750 IRR AT =10.6% 32 ENG3615-Engineering Economics

0 1 2 3 4 5 5

Example 12-5 Before-tax and After-tax Cash Flows

Initial Cost = $3000; Annual net saving= $800; Assume 34% incr. tax rate Useful life = 5 years; Salvage value = $750; Year (a) Before-tax Cash Flow -$3000 800 800 800 800 800 750 IRR BT =15.7% (b) Straight-Line Depreciation $450 450 450 450 450 (B-S)/N= (3000-750)/5 = 450 (c)=(a)-(b)  (Taxable Income) $350 350 350 350 350 (d) Income Tax (34%) $119 119 119 119 119 (e)=(a)-(d) After-tax Cash Flow -$3000 681 681 681 681 681 750 IRR AT =10.6% 33 ENG3615-Engineering Economics

Example 12-6 After-tax Cash Flows

Initial Cost (inventory) = $20,000; Annual net saving= $1,000, $1,500, $2,000, $2,500; Salvage value = $20,000; Useful life = 4 years; Year 0 1 2 3 4 4 (a) Before-tax Cash Flow -$20000 1000 1500 2000 2500 20000 IRR BT = 8.5% (b) Depreciation ENG3615-Engineering Economics (c)=(a)-(b)  (Taxable Income) $1000 1500 2000 2500 (d) Income Tax (39%) $390 585 780 975 (e)=(a)-(d) After-tax Cash Flow -$20000 610 915 1220 1525 20000 IRR AT = 5.2% 34

Capital Gains and Losses: Non-depreciated Assets

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

Example.

a) b) 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 firm’s accounting records (“the books”) reflect this change. If Selling Price > Original Cost Basis, then Capital gain = Selling price – Original Cost Basis ( > 0) If Selling price < Original Cost Basis, then Capital loss = Selling price – Original Cost Basis (< 0) 35 ENG3615-Engineering Economics

Capital Gains and Losses: Non-depreciated Assets

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 15% for assets held more than 12 months by individuals.

See a tax accountant or an attorney for advise here.

36 ENG3615-Engineering Economics

Table 12-5 Tax Treatment of Capital Gains & Losses

For Individuals

Capital Gain • For most assets held for less than 1 year, taxed as ordinary income • For most assets held for more than 1 year, taxed at 15% tax rate Capital Loss Capital Gain • • • Subtract capital losses from any capital gains; balance may be deducted from ordinary income, but not more than $3000 per year Excess capital losses may be carried forward indefinitely

For Corporations

Taxed as ordinary income Capital Loss • • Deduct capital losses only to the extent of capital gains Excess capital losses may be carried back 2 years, and, if not completely absorbed, is then carried forward for up to 20 years 37 ENG3615-Engineering Economics

Investment Tax Credit (ITC)

 ITC has been used to stimulate capital investments.

 Businesses were able to deduct a percentage of their new equipment purchases as a tax credit.

 Depending on the specific ITC provisions, the credit might or might not be subtracted from the basis for depreciation.

 Tax Reform Act of 1986 eliminated ITC for most assets, although credits are allowed in some specialized cases, such as historical building preservation and in the development of alternate energy sources.

ENG3615-Engineering Economics 38

Estimating the After-Tax Rate of Return

 For nondepreciable assets After-tax rate of return = (1 – Incremental tax rate) (Before-tax rate of return) ENG3615-Engineering Economics 39

Example 12-7 Calculation of the After-Tax Rate of Return

=Salvage =750.00 – BV – 345.60

ENG3615-Engineering Economics =IRR(J2..J7) =Taxed BTCF – Depr. + Recap. Depr.

=800.00 – 172.80 + 404.40

40

End of Chapter 12

ENG3615-Engineering Economics 41