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ENG3615-Engineering Economics 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 Chapter Outline 2

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ENG3615-Engineering Economics 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 Learning Objectives 3

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ENG3615-Engineering Economics Technology for renewable energy has been available for many years. Transition to greater use of wind power requires a significant investment. Vignette: On with the Wind 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. 4

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ENG3615-Engineering Economics 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 th century? How has this affected the value of tax credits to industry? Vignette: On with the Wind 5

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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. 6ENG3615-Engineering Economics

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U.S. Government is a partner in every business activity Government shares profits through income taxes Government shares losses through income taxes A Partner in the Business Related Point of View: Think of taxes as one more disbursement (like operating costs, maintenance, labor and materials, etc.) 7

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ENG3615-Engineering Economics Taxable Income of Individuals -Personal Exemption(s) -Itemized or Std. Deduction Wages, salary, etc Interest Income Dividends Capital Gains Unemployment Compensation +Other Income Gross Income -Retirement Contribution -Other Adjustments Adjusted Gross Income (AGI) Taxable Income 8

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ENG3615-Engineering Economics 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) Personal Exemption: One exemption per dependent ($3400 for 2007 returns) Standard Deduction: Single taxpayers, $5,350 for 2007 returns Married taxpayers filing jointly, $10,700 for 2007 returns Taxable Income of Individuals (2007) 9

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ENG3615-Engineering Economics 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) Personal Exemption: One exemption per dependent ($3650 for 2009 returns) Standard Deduction: Single taxpayers, $5,700 for 2009 returns Married taxpayers filing jointly, $11,400 for 2009 returns Taxable Income of Individuals (2009) 10

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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 Economics11

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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 Economics12

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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. labor costs; 2. materials; 3. all direct and indirect costs; 4. facilities and productive equipment with a useful life of one year or less. These are all routine expenditures. ENG3615-Engineering Economics13

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Classification of Business Expenditures Recall there are three distinct types of business expenditures: for depreciable assets; for non-depreciable assets; all other business 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 Economics14 Capital Expenditures Expense Expenditures

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15 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. Since the special tooling has a 3-year useful life, it is a capital expenditure. Year 1Year 2Year 3 Gross income from sales$200 Purchase of special tooling (useful life: 3 years) -$60 All other expenditures-$140 Cash results for the year$0$60 Example 12-1 Taxable Income ENG3615-Engineering Economics

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16 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. Year 1 Year 2 Year 3 Gross income from sales$200 Purchase of special tooling (useful life: 3 years) -$60 All other expenditures-$140 Cash results for the year$0$60 Example 12-1 Taxable Income ENG3615-Engineering Economics

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Example 12-1 Taxable Income Year 1Year 2Year 3 Gross income$200 Purchase of special tooling-6000 All other expenditures-140 Cash flows for the year$0$60 Actual cash flows: Taxable Income: Year 1Year 2Year 3 Gross income$200 All other expenditures-140 Depreciation charges-20 Cash flows for the year$40 17

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ENG3615-Engineering Economics Maximum Federal Income Tax Rates for Individuals 18

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2007 Individual Tax rates ENG3615-Engineering Economics19 Tax RateSingleMarried/JointMarried/Separate Head of Household 10%$0 15%$7,825$15,650$7,825$11,200 25%$31,850$63,700$31,850$42,650 28%$77,100$128,500$64,250$110,100 33%$160,850$195,850$97,925$178,350 35%$349,700 $174,850$349,700

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ENG3615-Engineering Economics 2007 Federal Income Tax Rates for Individuals Single Taxpayers Taxable IncomeTax OverBut Not OverBase TaxPlus On Income Over $07,825$0.0010%$0 7,82531,850782.5015%7,825 31,85077,1004,386.5025%31,850 77,100160,85015,698.7528%77,100 160,850349,70039,148.7533%160,850 Over 349,700101,469.2535%349,700 20

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ENG3615-Engineering Economics 2007 Federal Income Tax Rates for Individuals Married Individuals Filing Jointly Taxable IncomeTax OverBut Not OverBase TaxPlus On Income Over $0$15,650$0.0010%$0 15,65063,7001,565.0015%15,650 63,700128,5008,772.5025%63,700 128,500195,85024,972.5028%128,500 195,850349,70043,830.5033%195,850 Over 349,70094,601.0035%349,700 21

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2009 Individual Tax rates ENG3615-Engineering Economics22 Tax RateSingleMarried/JointMarried/Separate Head of Household 10%$0 15%$8,350$16,700$8,350$11,950 25%$33,950$67,900$33,950$45,500 28%$82,250$137,050$68,525$117,450 33%$171,550$208,850$104,425$190,200 35%$372,950 $186,475$372,950

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ENG3615-Engineering Economics 2009 Federal Income Tax Rates for Individuals Married Individuals Filing Jointly Taxable IncomeTax OverBut Not OverBase TaxPlus On Income Over $0$16,700$0.0010%$0 16,70067,9001,670.0015%16,700 67,900137,0509,350.0025%67,900 137,050208,85026,637.5028%137,050 208,850372,95046,741.5033%208,850 Over 372,950100,894.5035%372,950 23

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2011 Individual Tax rates ENG3615-Engineering Economics24 Tax RateSingleMarried/JointMarried/Separate Head of Household 10%$0 15%$8,500$17,000$8,500$12,150 25%$34,500$69,000$34,500$46,250 28%$83,600$139,350$69,675$119,400 33%$174,400$212,300$106,150$193,350 35%$379,150 $189,575$379,150

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ENG3615-Engineering Economics Example 12-2 - Taxable Income of Individuals $1000 (itemized deductions) < $5350 (standard deduc) Taxable Income = AGI - Exemption Standard Deduction = $16,000 3,400 5,350 = $7,250 Gross Income = Adjusted Gross Income (AGI) = $10,000+6000 = $16,000 An unmarried student earned $10,000 in the summer plus another $6000 during the rest of 2007. He is allowed one exemption and he spent $1000 on allowable itemized deductions. Tax = 10%(7,250) = $725 25

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ENG3615-Engineering Economics Problem 12-4 Taxable Income of Individuals Solution $4000 (itemized deductions) < $11400 (standard deduc) Taxable Income = AGI - Exemption Standard Deduction = $75,000 2(3,650) 11,400 = $56,300 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. Tax = 10%(16,700) + 15%(56,300 16,700) = $7,610 26

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ENG3615-Engineering Economics 27 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 overBut not overYour tax isOf the amount over $0$50,00015%$0 $50,000$75,0007,500 +25%$50,000 $75,000$100,00013,750 +34%$75,000 $100,000$335,00022,250 +39%$100,000 $335,000$10,000,000113,900 +34%$335,000 $10,000,000$15,000,0003,400,000 +35%$10,000,000 $15,000,000$18,333,3335,150,000 +38%$15,000,000 $18,333,333flat rate 35% Federal Corporate Income Tax Rates

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ENG3615-Engineering Economics 2007 Federal Corporate Income Tax Rates Taxable Income Tax RateCorporate Income Tax Not over $50,00015%15% over 0 $50,000-75,00025%7,500 + 25% over 50,000 $75,000-100,00034%13,750 + 34% over 75,000 $100,000-335,00039%22,250 + 39% over 100,000 $335,000-10 million34%113,900 + 34% over 335,000 $10 million-15 million35%3,400,000 + 35% over 10 mil. $15 million - 18,333,33338%5,150,000 + 38% over 15 mil. over $18,333,33335%6,416,667 + 35% over 18,333,333 28

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ENG3615-Engineering Economics Example 12-3 Federal Corporate Income Tax Chemical Equipment d 1 = $650000(14.29%) = $92,885 Federal Income Tax = $22,250+39%(240,744-100,000) = $77,140 Taxable Income = Gross Income Expenditures Depr. = $450,000 100,000 109,256 = $240,744 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. Total first year depreciation =$109,256 Building d 1 = $900,000(1.819%) = $16,371 29

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Table 11-3 MACRS GDS Percentage Rate Recovery Year 3-Year Class 5-Year Class 7-Year Class 10-Year Class 15-Year Class 20-Year Class 133.3320.0014.2910.005.003.750 244.4532.0024.4918.009.507.219 314.81*19.2017.4914.408.556.677 4 7.41 11.52*12.4911.527.706.177 511.528.93* 9.226.935.713 65.768.92 7.376.235.285 78.936.55*5.90*4.888 8 4.466.555.904.522 96.565.914.462* 106.555.904.461 113.285.914.462 12-155.904.461 162.954.461 17-204.462 212.231 30 ENG3615-Engineering Economics

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Table 11-4 MACRS GDS Percentage Rate Residential Rental Property Recovery YearMonth Placed in Service 123456789101112 1 3.4853.1822.8792.5762.2731.9701.6671.3641.0610.7580.4550.152 2-27 3.636 28 1.9702.2732.5762.8793.1823.4853.636 29 0.1520.4550.7581.0611.3641.667 Recovery YearMonth Placed in Service 123456789101112 1 2.4612.2472.0331.8191.6051.3911.1770.9630.7490.5350.3210.107 2-39 2.564 40 0.1070.3210.5350.7490.9631.1771.3911.6051.8192.0332.2472.461 Nonresidential Real Property 31 ENG3615-Engineering Economics

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Example 12-5 Before-tax and After-tax Cash Flows Initial Cost = $3000; Useful life = 5 years; Annual net saving= $800; Salvage value = $750; Assume 34% incr. tax rate Year (a) Before-tax Cash Flow (b) Straight-Line Depreciation (c)=(a)-(b) (Taxable Income) (d) Income Tax (34%) (e)=(a)-(d) After-tax Cash Flow 0 -$3000 1 800 $450$350$119681 2800450350119681 3800450350119681 4800450350119681 5800450350119681 5750 IRR BT =15.7% IRR AT =10.6% (B-S)/N= (3000-750)/5 = 450 32

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ENG3615-Engineering Economics Year (a) Before-tax Cash Flow (b) Straight-Line Depreciation (c)=(a)-(b) (Taxable Income) (d) Income Tax (34%) (e)=(a)-(d) After-tax Cash Flow 0 -$3000 1 800 $450$350$119681 2800450350119681 3800450350119681 4800450350119681 5800450350119681 5750 IRR BT =15.7% IRR AT =10.6% (B-S)/N= (3000-750)/5 = 450 33 Example 12-5 Before-tax and After-tax Cash Flows Initial Cost = $3000; Useful life = 5 years; Annual net saving= $800; Salvage value = $750; Assume 34% incr. tax rate

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ENG3615-Engineering Economics Example 12-6 After-tax Cash Flows Initial Cost (inventory) = $20,000; Useful life = 4 years; Annual net saving= $1,000, $1,500, $2,000, $2,500; Salvage value = $20,000; Year (a) Before-tax Cash Flow (b) Depreciation (c)=(a)-(b) (Taxable Income) (d) Income Tax (39%) (e)=(a)-(d) After-tax Cash Flow 0 -$20000 1 1000 $1000$390610 21500 585915 32000 7801220 42500 9751525 420000 IRR BT = 8.5% IRR AT = 5.2% 34

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35 Non-depreciable assets: land, minerals, stocks, bonds. Example. a) 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. b) 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 firms 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) Capital Gains and Losses: Non-depreciated Assets ENG3615-Engineering Economics

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36 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. ENG3615-Engineering Economics

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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 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 Capital Gain 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

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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. 38

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ENG3615-Engineering Economics Estimating the After-Tax Rate of Return For nondepreciable assets After-tax rate of return = (1 Incremental tax rate) (Before-tax rate of return) 39

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ENG3615-Engineering Economics Example 12-7 Calculation of the After-Tax Rate of Return =Salvage BV =750.00 345.60 =IRR(J2..J7) =Taxed BTCF Depr. + Recap. Depr. =800.00 172.80 + 404.40 40

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ENG3615-Engineering Economics End of Chapter 12 41