Depreciation Conclusion

Taxable Income

+ Gross Income - Depreciation Allowance - Interest on Borrowed Money - Other Tax Exemptions = Taxable Income

Corporate Tax Rate

Taxable Income Tax Rate Income Tax 0 < TI < 50,000 0.15 .15(TI)50,000 < TI < 75,000 0.25 7,500 + .25(TI - 50,000)75,000 < TI < 100,000 0.34 13,750 + .34(TI - 75,000)100,000 < TI < 335,000 0.39 22.250 + .39(TI - 100,000)

335,000 < TI < 10,000,000 0.34 113,900 + .34(TI - 335,000)10,000,000 < TI < 15,000,000 0.35 3,400,000 + .35(TI - 10,000,000)15,000,000 < TI < 18,333,333 0.38 5,150,000 + .38(TI - 15,000,000)

TI > 18,333,333 0.35 .35(TI)

Corporate Tax

Ex: Suppose K-Corp earns $5,000,000 in revenue above manufacturing and operations cost. Suppose further that depreciation costs total $800,000 and interest paid on short and long term debt totals $1,500,000. Compute the tax paid.

Corporate Tax

Gross Income $ 5,000,000Depreciation - 800,000Interest - 1,500,000Taxable Income $ 2,700,000

Corporate Tax

Gross Income $ 5,000,000Depreciation - 800,000Interest - 1,500,000Taxable Income $ 2,700,000

Tax = $ 113,900 + .34(2,700,000 - 335,000)

= $ 918,000

Methods of Depreciation

Straight Line (SL) Declining Balance (DB)

Prior to 1981 Modified Accelerated Cost Recovery

(MACRS) Depletion Sum-of-Years Digits (SYD)

Time Value of Tax Savings(Tax Rate = 40%)

Time Value of Tax Savings (40%)SL Tax DDB Tax

t Dt Save Dt Save

01 20,000 8,000 40,000 16,0002 20,000 8,000 24,000 9,6003 20,000 8,000 14,400 5,7604 20,000 8,000 8,640 3,4565 20,000 8,000 4,320 1,7286 0 0 8,640 3456

Sum = 100,000 40,000 100,000 40,000Present Value = 30,326 32,191

9

MACRSMACRSMACRSMACRS

• Prior to 1981, taxpayers could choose among several methods when depreciating assets for tax purposes.

• With the Economic Recovery Act of 1981, ACRS was required and MACRS was instituted in 1986.

• MACRS is a simpler, more rapid depreciation method.

MACRS Percentages 3,5,7, & 10 are 200% DB/SL15 & 20 are 150% DB/SL

t 3-Yr. 5-Yr. 7-Yr. 10-Yr. 15-Yr. 20-Yr.

1 33.33% 20.00% 14.29% 10.00% 5.00% 3.75%2 44.45% 32.00% 24.49% 18.00% 9.50% 7.22%3 14.81% 19.20% 17.49% 14.40% 8.55% 6.68%4 74.10% 11.52% 12.49% 11.52% 7.70% 6.18%5 11.52% 8.93% 9.22% 6.93% 5.71%6 5.76% 8.92% 7.37% 6.23% 5.29%7 8.93% 6.55% 5.90% 4.88%

8 4.46% 6.55% 5.90% 4.52%9 6.56% 5.91% 4.46%10 6.55% 5.90% 4.46%11 3.28% 5.91% 4.46%12 5.90% 4.46%13 5.91% 4.46%14 5.90% 4.46%15 5.91% 4.46%16 2.95% 4.46%17 4.46%18 4.46%19 4.46%20 4.46%21 2.23%

MACRS Tables

MACRS Percentages 3,5,7, & 10 are 200% DB/SL15 & 20 are 150% DB/SL

t 3-Yr. 5-Yr. 7-Yr. 10-Yr. 15-Yr. 20-Yr.

1 33.33% 20.00% 14.29% 10.00% 5.00% 3.75%2 44.45% 32.00% 24.49% 18.00% 9.50% 7.22%3 14.81% 19.20% 17.49% 14.40% 8.55% 6.68%4 74.10% 11.52% 12.49% 11.52% 7.70% 6.18%5 11.52% 8.93% 9.22% 6.93% 5.71%6 5.76% 8.92% 7.37% 6.23% 5.29%7 8.93% 6.55% 5.90% 4.88%8 4.46% 6.55% 5.90% 4.52%9 6.56% 5.91% 4.46%10 6.55% 5.90% 4.46%11 3.28% 5.91% 4.46%12 5.90% 4.46%13 5.91% 4.46%14 5.90% 4.46%15 5.91% 4.46%16 2.95% 4.46%17 4.46%18 4.46%19 4.46%20 4.46%21 2.23%

Modified Accelerated Cost

Property Classes3 yr. - useful life < 4 yrs.

autos, tools5 yr. - 4 yrs. < useful life < 10 yrs.

office epuipment, computers, machinery7 yr. - 10 < UL < 16

office furniture, fixtures, exploration10 yr. - 16 < UL < 20

vessels, tugs, elevators (grain)15 yr. - 20 < UL < 25

data communication, sewers, bridges, fencing

MACRS (Cont.)

20 yr. - UL > 25

farm buildings, electric generation27.5 - residential rental property31.5 - non-residential real property

Depreciationclass (3, 5, 7, 10 yr.) uses 200% declining balance switching to straight-line @ optimal yearclass (15, 20) 150% DB switch to SLDclass (27.5, 31.5) use straight-line

Class Problem

A company plans to invest in a water purification system (5 year property) requiring $800,000 capital. The system will last 7 years with a salvage of $100,000. The before-tax cash flow for each of years 1 to 6 is $200,000. Regular MACRS depreciation is used; the applicable tax rate is 34%. Construct a table showing each of the following for each of the 7 years.

Solution

Tax Rate = 34%MARR = 20%

Taxablet BTCF MACRS % Depr. Income Tax ATCF

0 (800,000) (800,000)1 200,0002 200,0003 200,0004 200,0005 200,0006 200,0007 300,000

NPV = ($51,173)

Solution

Tax Rate = 34%MARR = 20%

Taxablet BTCF MACRS % Depr. Income Tax ATCF

0 (800,000) (800,000)1 200,000 20.0% 160,000 40,000 13,600 186,4002 200,000 32.0% 256,000 (56,000) (19,040) 219,0403 200,000 19.2% 153,600 46,400 15,776 184,2244 200,000 11.5% 92,160 107,840 36,666 163,3345 200,000 11.5% 92,160 107,840 36,666 163,3346 200,000 5.8% 46,080 153,920 52,333 147,6677 300,000 0 300,000 102,000 198,000

NPV = ($51,173) ($136,824)

Depletion Method

Allows for equal depreciation for each unit of output

whereVt = volume extracted during the year

V = total volume available in reserve(I-S) = depreciable amount allowed

V

VSID t

t )(

Example

Ex: NorCo Oil has a 10 year, $27,000,000 lease on a natural gas reservoir in western South Dakota. The reservoir is expected to produce 10 million cubic ft. of gas each year during the period of the lease. Compute the expected depletion allowance for each year.

Example

Ex:

000,700,2$

000,000,1010

000,000,10000,000,27$

x

Dt

Percentage Depletion

Depletion is taken as a constant percentage of gross income

Allowable PercentagesOil/Gas 15%Natural Gas 22%Sulphur/Uranium 22%Gold, silver, … 15%Coal 10%

Example

Ex: NorCo Oil has a 10 year, $27,000,000 lease on a natural gas reservoir in western South Dakota. The reservoir is expected to produce 10 million cubic ft. of gas each year during the period of the lease at $1.50 per cubic ft.

Gross Income = 1.5(10,000,000)= 15,000,000

Depletion = 15,000,000 (0.22)= $3,300,000

22

Sum of Years Digits Sum of Years Digits MethodMethod

Sum of Years Digits Sum of Years Digits MethodMethod

SOYD = 1 + 2 + 3 + … + N

= N(N+1) 2

Dn = ( N – n + 1 ) ( I – S )

SOYD

Bn = Bn–1 – Dn

Depreciation Recapture

Ex: K-Corp purchases a Loader for $250,000 which has a 7 year property class life. After 3 years, $140,675 has been depreciated and the book value is now $109,325. K-Corp now sells the loader for $150,000.

Depreciation Recapture

Ex: K-Corp purchases a Loader for $250,000 which has a 7 year property class life. After 3 years, $140,675 has been depreciated and the book value is now $109,325. K-Corp now sells the loader for $150,000.

Recapture = 150,000 - 109,325 = $40,675

Depreciation Recapture

Ex: K-Corp purchases a Loader for $250,000 which has a 7 year property class life. After 3 years, $140,675 has been depreciated and the book value is now $109,325. K-Corp now sells the loader for $150,000.

Recapture = 150,000 - 109,325 = $40,675

$40,675 taxed as ordinary income

Depreciation Recapture

Ex: Suppose K-Corp were able to sell this same loader for $ 275,000.

Capital Gain = 275,000 - 250,000 = $25,000

Depr. Recapture = 250,000 - 109,325 = $140,675

Depreciation Recapture

Ex: Suppose K-Corp were able to sell this same loader for $ 275,000.

Capital Gain = 275,000 - 250,000 = $25,000

Depr. Recapture = 250,000 - 109,325 = $140,675

$ 25,000 taxed at 28%$140,675 taxed at 35%