Corporate Taxes
Lecture No.25
Professor C. S. Park
Fundamentals of Engineering Economics
Copyright © 2005
Taxable Income and Income Taxes
Item
Gross Income
Expenses
Cost of goods sold (revenues)
Depreciation
Operating expenses
Taxable income
Income taxes
Net income
U.S. Corporate Tax Rate (2005)
Taxable income
Tax rate
0-$50,000
15%
$50,001-$75,000
25%
$75,001-$100,000
34%
$100,001-$335,000
39%
$335,001-$10,000,000
34%
$10,000,001-$15,000,000 35%
$15,000,001-$18,333,333 38%
$18,333,334 and Up
35%
Tax computation
$0 + 0.15(D)
$7,500 + 0.25 (D)
$13,750 + 0.34(D)
$22,250 + 0.39 (D)
$113,900 + 0.34 (D)
$3,400,000 + 0.35 (D)
$5,150,000 + 0.38 (D)
$6,416,666 + 0.35 (D)
(D) denotes the taxable income in excess of the lower bound of
each tax bracket
Marginal and Effective (Average) Tax Rate for a
Taxable Income of $16,000,000
Taxable income
Marginal
Tax Rate
Amount of
Taxes
Cumulative
Taxes
First $50,000
15%
$7,500
$7,500
Next $25,000
25%
6,250
13,750
Next $25,000
34%
8,500
22,250
Next $235,000
39%
91,650
113,900
Next $9,665,000
34%
3,286,100
3,400,000
Next $5,000,000
35%
1,750,000
5,150,000
Remaining
$1,000,000
38%
380,000
$5,530,000
Average tax rate =
$5,530,000
 34.56%
$16,000,000
Example 8.10 - Corporate Income Taxes
Facts:
Capital expenditure
(allowed depreciation)
Gross Sales revenue
Expenses:
Cost of goods sold
Depreciation
Leasing warehouse
Question: Taxable income?
$100,000
$58,000
$1,250,000
$840,000
$58,000
$20,000
Taxable income:
Gross income
- Expenses:
(cost of goods sold)
(depreciation)
(leasing expense)
Taxable income
• Income taxes:
First $50,000 @ 15%
$25,000 @ 25%
$25,000 @ 34%
$232,000 @ 39%
Total taxes
$1,250,000
$840,000
$58,000
$20,000
$332,000
$7,500
$6,250
$8,500
$90,480
$112,730
• Average tax rate:
Total taxes =
$112,730
Taxable income = $332,000
$112,730
Average tax rate =
$332,000
 33.95%
• Marginal tax rate:
Tax rate that is applied to the last dollar
earned
39%
Disposal of Depreciable Asset
• If
a MACRS asset is disposed of during the
recovery period,
• Personal property: the half-year convention
is applied to depreciation amount for the year
of disposal.
• Real property: the mid-month convention is
applied to the month of disposal.
Disposal of a MACRS Property and Its
Effect on Depreciation Allowances
Depreciation recapture
Depreciation recapture is taxed as ordinary income.
Gains = Salvage value – book value
= (Salvage value - cost basis)
Capital gains
+ (Cost basis – book value)
Ordinary gains
Capital Gains and Ordinary Gains
Capital gains
Total gains
Ordinary gains
or
depreciation recapture
Cost basis
Book value
Salvage value
Gains or Losses on Depreciable Asset
Example 8.11: A Drill press: $230,000
Project year: 3 years
MACRS:
7-year property class
Salvage value: $150,000 at the end of Year 3
Full
Full
Half
8.92
8.92
14.29 24.49 17.49 12.49
8.92
Total Dep. = 230,000(0.1439 + 0.2449 + 0.1749/2) = $109,308
Book Value = 230,000 -109,308 = $120,693
Gains = Salvage Value - Book Value = $150,000 - $120,693
= $29,308
Gains Tax (34%) = 0.34 ($29,308) = $9,965
Net Proceeds from sale = $150,000 - $9,965 = $140,035
Calculation of Gains or Losses on MACRS
Property
Summary



The entire cost of replacing a machine cannot be
properly charged to any one year’s production;
rather, the cost should be spread (or capitalized)
over the years in which the machine is in service.
The cost charged to operations during a
particular year is called depreciation.
From an engineering economics point of view,
our primary concern is with accounting
depreciation; The systematic allocation of an
asset’s value over its depreciable life.


Accounting depreciation can be broken into two
categories:
1. Book depreciation—the method of
depreciation used for financial reports and pricing
products;
2. Tax depreciation—the method of depreciation
used for calculating taxable income and income
taxes; it is governed by tax legislation.
The four components of information required to
calculate depreciation are:
(a) cost basis, (b) salvage value, (c) depreciable
life , and (4) depreciation method.
•Because it employs accelerated methods of
depreciation and shorter-than-actual depreciable
lives, the MACRS (Modified Accelerated Cost
Recovery System) gives taxpayers a break: It
allows them to take earlier and faster advantage
of the tax-deferring benefits of depreciation.
•The total amount of taxes to pay remains
unchanged regardless of depreciation methods
adopted. It only changes the timing of the
payment.
•Many firms select straight-line depreciation for
book depreciation because of its relative ease of
calculation.

Given the frequently changing nature of
depreciation and tax law, we must use whatever
percentages, depreciable lives, and salvage
values mandated at the time an asset is
acquired.
Component of
Depreciation
Cost basis
Book Depreciation
Based on the actual cost
of the asset, plus all
incidental costs such as
freight, site preparation,
installation, etc.
Salvage value Estimated at the outset of
depreciation analysis. If
the final book value does
not equal the estimated
salvage value, we may
need to make adjustments
in our depreciation
calculations.
Tax depreciation (MACRS)
Same as for book
depreciation
Salvage value is zero for
all depreciable assets
Component
of
Depreciation
Book Depreciation
Tax depreciation (MACRS)
Depreciable
life
Firms may select their
own estimated useful
lives or follow
government guidelines
for asset depreciation
ranges (ADRs)
Eight recovery periods–
3,5,7,10,15,20,27.5,or 39 years–
have been established; all
depreciable assets fall into one
of these eight categories.
Method of
depreciation
Firms may select from
the following:
Straight-line
Accelerated methods
(declining balance,
double declining
balance, and sum-ofyears’ digits)
Units-of-proportion
Exact depreciation percentages
are mandated by tax legislation
but are based largely on DDB
and straight-line methods. The
SOYD method is rarely used in
the U.S. except for some cost
analysis in engineering
valuation.


Explicit consideration of taxes is a necessary
aspect of any complete economic study of an
investment project.
Once we understand that depreciation has a
significant influence on the income and cash
position of a firm, we will be able to appreciate
fully the importance of utilizing depreciation as a
means to maximize the value both of engineering
projects and of the organization as a whole.
• For corporations, the U.S. tax system has the
following characteristics:
1. Tax rates are progressive: The more you
earn, the more you pay.
2. Tax rates increase in stair-step fashion:
four brackets for corporations and two
additional surtax brackets, giving a total
of six brackets.
3. Allowable exemptions and deductions
may reduce the overall tax assessment.





Marginal tax rate is the rate applied to the last
dollar of income earned;
Average (effective) tax rate is the ratio of income
tax paid to net income; and
Incremental tax rate is the average rate applied
to the incremental income generated by a new
investment project.
Capital gains are currently taxed as ordinary
income, and the maximum rate is capped at
35%.
Capital losses are deducted from capital gains;
net remaining losses may be carried backward
and forward for consideration in years other than
the current tax year.