Income Tax

Income Tax

Taxes are of various types, such as sales taxes, gasoline taxes, property taxes, and income taxes. In this chap- ter we focus on the income taxes imposed on the earnings of private, for-profit companies. These include taxes on both ordinary income and on capital gains. Our coverage here examines only the fundamental concepts of income tax laws that apply to most businesses.

Corporate Financial Analysis with Microsoft Excel

Table฀11-2

MACRS Depreciation (For property placed in service after December 31, 1986)

3-Year Property

(Tractor฀units฀for฀use฀over฀the฀road,฀race฀horses฀over฀two฀years฀old,฀and฀any฀other฀horses฀over฀12฀years฀old)

Mid-Quarter Convention

Half-Year

Quarter฀in฀which฀acquired

Year Convention

5-Year Property

(Taxis,฀buses,฀automobiles,฀light฀trucks,฀computers,฀typewriters,฀calculators,฀and฀copiers)

MACRS Depreciation

Optional Straight-Line Depreciation

Mid-Quarter Convention

Mid-Quarter Convention

Half-Year

Quarter฀in฀which฀acquired

Half-Year

Quarter฀in฀which฀acquired

Year Convention

1st

2nd

3rd

4th

Convention

1st

2nd

3rd

4th

7-Year Property

(Office฀furniture฀fixtures,฀equipment,฀and฀any฀property฀that฀does฀not฀have฀a฀class฀life฀and฀that฀is฀not,฀by฀law,฀in฀any฀other฀class)

MACRS Depreciation

Optional Straight-Line Depreciation

Mid-Quarter Convention

Mid-Quarter Convention

Half-Year

Quarter฀in฀which฀acquired

Half-Year

Quarter฀in฀which฀acquired

Year Convention

MACRS—RESIDENTIAL RENTAL PROPERTY, 27.5-YEAR DEPRECIABLE LIFE

(Residential฀houses฀and฀apartments)฀

Straight-Line, Mid-Month Convention Month Placed in Service

3.636 3.636 Depreciation and Taxes 13 3.636

(Continued) ❧

Corporate Financial Analysis with Microsoft Excel

Table฀11-2

MACRS Depreciation (For property placed in service after December 31, 1986) (Continued)

MACRS—NONRESIDENTIAL REAL PROPERTY, 39-YEAR DEPRECIABLE LIFE

(Nonresidential฀rental฀property฀such฀as฀office฀buildings,฀warehouses,฀and฀qualified฀home฀offices฀that฀were฀placed฀into฀service฀after May 12, 1993)

Straight-Line, Mid-Month Convention Month Placed in Service

MACRS—NONRESIDENTIAL REAL PROPERTY, 31.5-YEAR DEPRECIABLE LIFE

(Nonresidential฀rental฀property฀such฀as฀office฀buildings,฀warehouses,฀and฀qualified฀home฀offices฀that฀were฀placed฀into฀service฀after December 31, 1986฀and฀ before May 12, 1993 )฀

Straight-Line, Mid-Month Convention Month Placed in Service

Year 1 2 3 4 5 6 7 8 9 10 11 12 1 3.042%

Depreciation and Taxes ❧ 357 Figure฀11-5

MACRS Depreciation

1 Example 11-5: MODIFIED ACCELERATED COST RECOVERY SYSTEM DEPRECIATION

2 Asset cost $75,000 3 Life, years 5 4 Asset placed into service in second quarter of year 1

5 Depreciation Schedule

Year

7 1 2 3 4 5 6 8 MACRS, 2nd quarter convention 25.00% 30.00%

18.00% 11.37% 11.37% 4.26% 9 Book value, beginning of year 75,000 $ 56,250 $ 33,750 $ 20,250 $ 11,723 $ 3,195 $ 10 Annual depreciation 18,750 $ 22,500 $ 13,500 $ 8,528 $ 8,528 $ 3,195 $ 11 Book value, end of year 56,250 $ 33,750 $ 20,250 $ 11,723 $ 3,195 $ $ - 12 Accumulated depreciation

15 ASSET COST = $75,000 16 $80,000

17 BOOK VALUE, BEGINNING OF YEAR

YEAR-END BOOK VALUE 29

ANNUAL DEPRECIATION ANNUAL DEPRECIATION

YEAR NUMBER

SALVAGE VALUE = 0 38

Key Cell Entries

B9: =B2 C9: =B11, copy to D9:G89

B10: =$B2*B8, copy to C10:G10 B11: =B9–B10, copy to C11:G11 B12: =SUM($B10:B10), copy to C12:G12

358 ❧ Corporate Financial Analysis with Microsoft Excel ®

Table 11-3 summarizes the steps in moving from a company’s income to its after-tax cash flow.

Table฀11-3

From Sales Revenues to Net Income after Taxes Sales Revenues (i.e., income from sale of goods or services)

–฀ Cost฀of฀Goods฀Sold฀(COGS)

Gross Profit

–฀ General฀and฀Administrative฀Expenses

Net Operating Income

+฀ Other฀Income฀(e.g.,฀capital฀gains,฀interest฀income,฀and฀insurance฀proceeds) –฀ Other฀Expenses฀(e.g.,฀capital฀losses฀and฀dividends)

Net Income before Taxes (or, Before-Tax Cash Flow)

–฀ Depreciation

Taxable Income

–฀ Federal฀Income฀Tax –฀ State฀Income฀Tax –฀ Local฀Income฀Tax

Net Income after Taxes (or, After-Tax Cash Flow)

Taxable Regular Income The amount of a firm’s taxes depends on its taxable income and the applicable tax rate. To calculate a

firm’s taxable income, we start with its total or gross receipts or sales, less any returns and allowances. From this we subtract the cost of goods sold (COGS) to determine the gross profit. In general, COGS is the price of buying or the cost of making an item that is sold. For retail firms, COGS is the purchase price of the items sold. For manufacturers, COGS is the sum of the direct material (i.e., raw materials, parts, and components), labor, and factory overhead expenses incurred in producing the finished products that are sold. Under the Uniform Capitalization Rules, a business may also be required to include an allocated portion of most indirect costs in computing COGS.

The net operating income is next calculated by deducting the normal operating expenses from the gross profit. Normal operating expenses are all ordinary and necessary expenses to conduct the business, other than capital expenditures. Examples include the compensation paid to corporate officers, employee salaries and wages, certain repair and maintenance expenses, rents, license fees, employee benefits, and so forth. These are classified as General and Administrative Expenses (G&A).

Except for land, the cost of any capital expenditure is recovered through depreciation, amortiza- tion, or depletion charges. (Depletion charges are similar to depreciation but apply to the exhaustion of natural resources such as mineral properties, oil and gas wells, and standing timber as a result of their removal.)

Depreciation and Taxes ❧ 359 When an asset is sold, there is usually a capital gain or loss. Net capital gain income (or loss) is added

to (or subtracted from) other income to determine the firm’s taxable income. (There are specific rules for calculating net capital gain or loss that must be followed.)

Finally, the taxable income is calculated by subtracting other deductible expenses, such as the inter- est on loans or mortgages and depreciation from the sum of the net operating income and net capital-gain income.

Types of Business The most common types of business are Corporations (or C Corporations), S Corporations, Partnerships, Sole

Proprietorships, and Limited Liability Companies (LLC). Each type has different legal and tax considerations. The following information is quoted from the IRS Web site, www.irs.gov/businesses, which can be accessed for detailed information on taxes and instructions for filling out the tax forms.

Corporations (also know as C Corporations): In forming a corporation, prospective shareholders exchange money, property, or both, for the corporation’s capital stock. A corporation generally takes the same deductions as a sole proprietorship to figure its taxable income. A corporation can also take special deductions. For federal income tax purposes, a C corporation is recognized as a separate taxpaying entity. A corporation conducts busi- ness, realizes net income or loss, pays taxes, and distributes profits to shareholders. The profit of a corporation is taxed to the corporation when earned, and then is taxed to the shareholders when distributed as dividends. This creates a double tax. The corporation does not get a tax deduction when it distributes dividends to shareholders. Shareholders cannot deduct any loss of the corporation.

S Corporations: An eligible domestic corporation can avoid double taxation (once to the shareholders and again to the corporation) by electing to be treated as an S corporation. Generally, an S corporation is exempt from federal income tax other than tax on certain capital gains and passive income. On their tax returns, the S corporation’s shareholders include their share of the corporation’s separately stated items of income, deduction, loss, and credit, and their share of nonseparately stated income or loss.

Partnerships: A partnership is the relationship existing between two or more persons who join to carry on a trade or business. Each person contributes money, property, labor or skill, and expects to share in the profits and losses of the business. A partnership must file an annual information return to report the income, deductions, gains, losses, etc. from its operations, but it does not pay income tax. Instead, it “passes through” any profits or losses to its partners. Each partner includes his or her share of the partnership’s income or loss on his or her tax return.

Sole Proprietorships: A sole proprietor is someone who owns an unincorporated business by himself or her- self. However, if you are the sole member of a domestic limited liability company (LLC), you are not a sole proprietor if you elect to treat the LLC as a corporation.

Limited Liability Companies (LLC): A Limited Liability Company (LLC) is a relatively new business struc- ture allowed by state statute. LLCs are popular because, similar to a corporation, owners have limited personal liability for the debts and actions of the LLC. Other features of LLCs are more like a partnership, providing management flexibility and the benefit of pass-through taxation.

Owners of an LLC are called members. Since most states do not restrict ownership, members may include individuals, corporations, other LLCs, and foreign entities. There is no maximum number of members. Most states also permit “single member” LLCs: those having only one owner.

A few types of businesses generally cannot be LLCs, such as banks and insurance companies. Check your state’s requirements and the federal tax regulations for further information. There are special rules for foreign LLCs.

360 ❧ Corporate Financial Analysis with Microsoft Excel ®