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Chapter 01 DE w Taxes and Taxing Jurisdictions Mchw HilIIrwin Copyright 2012 by The Mchw Hill Companies Inc All rights reserved De nMons Tax compulsory payment to support the cost of government contrast with finepenalty or user fee Taxpayer any person or organization that pays tax includes individuals and corporations Incidence ultimate economic burden of a tax May not fall on the person or organization who pays tax Jurisdiction right of a government to tax 1 a The statement of facts identifies three taxpayers Mr JK JK Services and JK Realty b The government of the locality in which Mr JK resides the state government of Vermont and the US government have jurisdiction to tax Mr JK The local governments of the four counties in which JK Services conducts business the state government of Vermont and the US government have jurisdiction to tax JK Services The city of Boston the state government of Massachusetts and the US government have jurisdiction to tax JK Realty 2 a The United States has jurisdiction to tax Mrs CM because she is a permanent resident b The United States has jurisdiction to tax Mrs CM only on the US source income generated by the Manhattan real estate c The United States does not have jurisdiction to tax Mrs CM d The United States has jurisdiction to tax Mrs CM because she is a citizen 4 Issue Recognition Problem Does State A have jurisdiction to tax the retirement income that Mrs O earned while she was a resident of State A but that she receives while she is a resident of State K Tax Formula Tax rate X base Rate can be Flat single rate applies to entire tax base Graduated multiple rates apply to portions brackets of tax base Base is an item occurrence transaction or activity on which a tax is levied expressed in monetary terms Revenue is total tax collected by the government Increased by increasing either rate or base 4 Increase in County G s aggregate assessed property tax value 23000000 Assessed value of Company Ll s new facility 20000000 Net increase in County G s tax base 3000000 Tax rate 04 Net effect on County G s current year revenue 120M California waived sales tax on Tesla s purchases of manufacturing equipment for the Milpitas Plant Two Ways to Characterize Taxes Frequency with which tax occurs Transaction event based taxes such as Sales or excise tax a Estate or gift tax Activity based tax such as Income tax Link to specific government expenditures Earmarked to finance designated projects such as a Social Security and Medicare EPA s environment excise taxes State and Local Taxes Property ad valorem taxes 0 Real property tax Abatements often granted to entice new business 0 Personal property tax Household tangibles vehicles Business tangibles Intangibles securities State and Local Taxes Salesuse Broadbased but typically excludes necessities food drugs Personal responsibility for use tax Excise tax Imposed on retail sale of specific goods or services Cigarettes and gasoline a Hotel and motel accommodations Income tax Personal Corporate 110 6 b a Value of property purchased in Jurisdiction K Use tax rate in Jurisdiction H Pre credit use tax Sales tax paid to Jurisdiction K Use tax owed to Jurisdiction H Value of property purchased in Jurisdiction L Use tax rate in Jurisdiction H Pre credit use tax Sales tax paid to Jurisdiction L Use tax owed to Jurisdiction H 600000 06 36000 18000 18000 750000 06 45000 48750 0 Sales Tax Expansion l The Supreme Court case of Quill Corporation vs North Dakota held that mailorder companies need not collect use tax from customers located in states where the company did not have physical presence What are the implications for the internet 112 a State R residents who purchase property outofstate ie through the mail but use and consume the property in State R owe the 6 percent use tax b Very few people actually pay a self assessed use tax Thus State R might collect as much as 1080000 additional revenue 6 percent of 18 million sales to State R customers if Firm L was required to collect use tax at point of sale and remit the tax to State R 9 a Mr and Mrs CS are not required to pay sales tax on the purchase of inventory goods because they are not the final consumers of the goods The hardware store s retail customers must pay the sales tax when they purchase goods Mr and Mrs CS are required to collect this tax at point of sale b Mr and Mrs CS should time their purchases to minimize their inventory on hand as of December 31 of each year thereby minimizing the book value on which the personal property tax is based Federal Taxes Individual income tax Corporate income tax Employment taxes Social Security Medicare Unemployment taxes Excise taxes tobacco luxury cars firearms Transfer taxes Gift Estate Generationskipping 115 History of Federal Income Tax Pre1861 tariffs excise and property taxes First income tax enacted to pay for Civil War in 1861 expired in 1871 First permanent income tax passed in 1894 but struck down by Supreme Court as unconstitutional Sixteenth Amendment ratified in 1913 made the income tax constitutional Internal Revenue Code was enacted in 1939 and subsequently revised in 1954 and 1986 116 Foreign Taxes Income taxes similar to US Value added tax VAT Similar to a sales tax on the incremental value added by a business at each stage of the production process Business can claim a credit for VAT paid to a supplier with proof of payment 117 10 Firm Q Firm R Sales revenue 9 x 124 million units Cost of sales 6 x 124 million units Value added by Firm Q Tax rate VAT Sales revenue 10 x 124 million units Cost of sales 9 x 124 million units Value added by Firm R Tax rate VAT 111600000 74400000 37200000 03 1116000 124000000 111600000 12400000 03 372000 9 Issue Recognition Problem Does the fact that Dempsey Corporation sells goods to US customers give the United States jurisdiction to tax the Canadian corporation Is the income generated by Dempsey s sales to US customers considered US source income subject to federal income tax Jurisdictional Competition Increasing the tax rate or expanding the definition of the tax base can cause taxpayers to flee the tax jurisdiction Ex Tax evasion in Greece is estimated at 25 to 35 of Greek GDP One proposal is to lower the rates to encourage compliance Current trends in increasing the tax base Annexation to expand city property Gamblinglotteries Sales tax expansion 120 10 Issue Recognition Problem When Mr KW dies can the United States government claim jurisdiction to impose the federal estate tax on his net worth Can an individual who has been a US citizen escape federal taxation by renouncing his citizenship and moving to a foreign country 1 Tax Planning Problem WP s management must compare the tax costs of operating in each jurisdiction Value of tangible business property 10000000 Jurisdiction F s property tax rate 04 400000 Annual gross receipts 2000000 Jurisdiction F s gross receipts tax rate 15 300000 Tax cost of operating in Jurisdiction F 700000 Annual gross receipts 2000000 Jurisdiction G s gross receipts tax rate 30 Tax cost of operating in Jurisdiction G 600000 Based solely on the comparative tax costs WP should locate its new branch in Jurisdiction G 2 Tax Planning Problem Before the tax increase KTR s taxable income was 200 million 10 profit per unit x 20 million units its income tax cost was 40 million and its aftertax profit was 160 million If KTR s taxable income does not change the rate increase from 20 percent to 22 percent would increase the income tax cost to 44 million and decrease aftertax profit to 156 million 2 Continued f KTR increases its profit per unit to 1020 but sells only 19 million units its taxable income will decrease to 1938 million Its tax on this income will be 42636 million and its aftertax profit will be 151164 million Thus KTR s owners will maximize aftertax profit if they do not raise the price of their product Sources of Tax Law Statutory authority is the Internal Revenue Code Administrative authority Treasury regulations IRS Revenue Rulings and Revenue Procedures Federal judicial authority Supreme Court Appellate courts Trial courts a Tax Court a District Court a Court of Federal Claims 125 Chapter 11 SEC The Corporate Taxpayer McGrtw HilIIrm39n Copyright 2012 by The McGraw Hill Compmt39ex Inc All rightx renewed Affiliated Groups and Consolidations AAffiliated groups a parent corporation that directly owns at least 80 of at least one domestic subsidiary all other domestic subsidiaries that are 80 owned within the group AAffiliated groups may elect to file a consolidated tax return applies to all members of affiliated group Advantage losses and profits of affiliated members offset each other Discussion Problem 4 The three family corporations form a brothersister controlled group but not an affiliated group Consequently the three corporations are ineligible to file a consolidated return Affiliated group must own more then 90 of the Discussion Problem 5 Although RP legally controls QV its 59 percent ownership falls far short of the 80 percent required to form an affiliated group Consequently RP and QV are ineligible to file a consolidated return Application Problem 3a a Corporation P s Separate Return Ordinary operating income loss 500000 Capital gain 0 Section 1231 gain loss 100 Capital loss deductible to extent of capital and Section 1231 gain 0 Taxable income NOL 499000 Corporation To Separate Return 200000 6000 5000 189000 Application Problem 3b b Consolidated Return Ordinary operating income 300000 Capital gain 6000 Net Section 1231 gain 4000 Deductible capital loss 8300 Taxable income 301 700 Nonprofit Corporations 308 Alncludes corporations formed exclusively for religious charitable scientific literary educational purposes etc ASection 501c3 organizations require IRS recognition of taxexempt status A Nevertheless taxexempt organizations may pay tax on unrelated business taxable income Computing Corporate Taxable Income APage 1 of the Form 1120 resembles a financial income statement or a Schedule C in a personal tax return Ch 10 See Chapters 6 7 8 and 9 for general rules on business income Corporations entitled to dividendsreceived deduction Deduct charitable contributions up to 10 of taxable income BEFORE Charitable deductions and before dividendsreceived deduction i Excess contributions can be carried fonNard for 5 years Dividendsreceived Deduction ACorporations receiving dividends from other taxable domestic corporations are entitled to this deduction Ownership Deduction A lt 20 of stock 70 DRD A20lt lt 80 80 DRD A80lt 100 DRD AWhat was Congress reasoning behind the DRD ATo mitigate triple taxation AAdditional details DRD can t create loss Dividends Received Deduction Example AAragorn Corp owns 35 of Ent Corp and 88 of Legolas Corp lfAragorn receives dividends of 10000 from Ent and 15000 from Legolas calculate Aragorn s DRD 10000x 80 8000 15000 x 100 15000 Total DRD 23000 1110 Application Problem 4 310 Napa Corporation s dividendsreceived deduction is 158500 KLP dividend 55000 x 70 38500 Gamma dividend 120000 x 100 120000 158500 Discussion Problem 7 The dividendsreceived deduction was enacted to mitigatelessen the double tax that would occur when one corporation subject to federal tax distributes aftertax income as a dividend to a second corporation also subject to federal tax If the distributing corporation is a foreign corporation not subject to federal tax the problem of double taxation by the United States government doesn t arise and the dividendsreceived deduction is unnecessary Book Versus Taxable Income Schedule M1 amp M3 ASchedules M1 and M3 reconcile book income to taxable income AThe M1 was used by all corporations until 2004 and can still be used by corporations with total assets less than 10 million Aln 2004 the IRS developed the M3 for use by large corporations assets gt 10 million it requires more detailed information than the M1 and enhances the transparency of booktax differences 1113 Schedule M1 ANet book income line 1 AFederal tax expense for books line 2 ALines 3 6 explain increases in taxable income relative to books ALines 7 9 explain decreases in taxable income relative to books ALine 10 taxable income before NOL and DRD Line 28 page 1 form 1120 Example Schedule M1 AWilson Inc reported 149250 of net income after tax on its financial statements Wilson reported federal income tax expense of 61250 Meals and entertainment expense 15000 MACRS depreciation 60000 book depreciation 42000 Prepare Wilson lnc s M1 Net book income 149250 3 Federal tax expense 61250 i 50 of meals amp ent 7500 MACRS over SL 18000 HTaxable Income 200000 Application Problem 11a 11 a Book income Less DRD Less excess tax depreciation Less muni bond interest Plus excess capital loss Plus federal income tax Taxable income Tax liability M1 311 Regular Tax E 1 l I 500000 10500 15000 5000 2000 249000 720500 244970 Application Problem 11b Reconciliation oi Income Lossi pe r Books With income per Heiiim bit imm Ii roe 1 Netincomeiosojporbooks 5mm 7 Incomorecomedonbooksthisyeamoi 2 wm 249000 quot 3 r quot Lupimigniria 100 T 39 39 4 Income subject to tax iioI recovded on books Iiiisyearirlamizei 9 n4 A A i 4 Expenses wooded on books this yeai iiDl deducled on His relum iiiemize Depreciaiion 0 Chan iabieconirihuiions ii i vaaiandamenainlnenl 0 cm 6 AddiinesHhrougiiS 751000 gt 3 against book income Uiia year itemize Depreciation o 1 000 b Chaiiiabieconiiibuiions 0 9 Addiineshnd 10 Income ipaga 1i iine ZBHine 6 ioss ilnsB 5000 Do Application Problem 12 Computing Regular Tax AThe surtax rates of 39 and 38 eliminate bracket benefits for rich corporations ACorporations with taxable income Between 335000 and 10 million H actually pay a flat rate of 34 Greater than 1833 million pay a flat rate of 35 APersonal service corporations are taxed at a flat 35 rate Includes health law engineering architecture accounting actuarial science performing arts amp consulting professionals 1119 Application Problem 7a The 100000 charitable contribution has an after tax cost of 66000 100000 34000 tax savings from current deduction at 34 percent Application Problem 7b Fig can deduct 49000 of the contribution this year and 51000 as a contribution carryforward next year The aftertax cost of the contribution is 66988 Contribution 100000 Current tax savings 49000 x 34 16660 Tax savings next year 51000 x 34 x 943 discount factor 16352 66 988 Application Problem 7c Fig can deduct 19000 of the contribution this year and 13000 in each of the next five years The remaining 16000 contribution carryforward expires The aftertax cost of the contribution is 71235 Contribution 100000 Current tax savings 19000 x 39 7410 NPV of future tax savings 13000 x 39 x 4212 discount factor 21 355 Domestic Production Activities Deduction AAvaiIable to US taxpayers deriving income from domestic production activities AFor 2011 deduction is equal to 9 of the lesser of net production income or taxable income before the deduction ADeduction can t exceed 50 of US compensation expense ADeduction is equivalent to a reduced M quot tax rate on domestic production income 1123 Application Problem 13a Book Sales revenue 2000000 Cost of goods sold 1200000 Net profit 800000 Meals and entertainment 100000 Bad debt expense 30000 Depreciation expense 80000 Other operating expenses 220000 Contingent loss 50000 Income before taxes 320000 Federal income taxes 130000 Net income 190000 BookT ax Diff 50000 8000 15000 50000 130000 Tax 2000000 1 200000 800000 50000 22000 95000 220000 0 0 413000 Application Problem 13b Schedule Mt Reconciliation 01 Income Loss par Books With Income per Return 1 u k 03900 7 Income vecovded on books this yeav not 2 Federailncometakpetbuoks Moo 39 a r g quot minim 39 r39 4 Income subjocl to tax not wounded on books this year itemize VVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVV v 0 Expenses vecorded on books this year not deducted on this vetum memos D predation Citatitabie contrihulions 0 vaei and entevtainlnent 5 Con Ira 50000 a 1 Add knest thruughS 100000 9 420000 10 antpiectation 0 1 39 b Chantabie contnbuiiom i V Deductions on this return not chaiged against book income this year itemize 5 000 Add mes 7 and E Income Luage t tine ZBJ tine 6 iess line9 413000 Tax Credits ACredits directly reduce computed tax H 1 of credit provides 1 of benefit 1 of deduction only provides 1 x the tax rate of benefit ATaX credits are generally limited to some of tax before credits Often a provision permits carry back or carry fonNard of excess credits ABiggest credits RampD credit foreign tax credit see Chapter 13 1126 Tax Credits ATo be eligible taxpayers must engage in specific activities that Congress believes are worthy of government support AThe list of credits changes as Congress experiments with new credits and discards those 1127 Application Problem 10a Allowable rehab credit 800000 20 4000000 Aftertax purchase price of historic building is 6200000 3000000 purchase price 4000000 rehab costs 800000 credit Application Problem 10b Landover should acquire the historic building because its after tax cost of 6200000 is less than the 6500000 cost of the new building Application Problem 10c If the credit cannot be used immediately its value is less than 800000 Depending on the length of time until Landover expects to be profitable if the NPV of the credit drops below 500000 the decision would change Alternative Minimum Tax AA second federal tax system parallel to the regular income tax ACreated to ensure that every corporation pays a fair share of taxes AM 11 V Ill fl 1 1r 1 4 A 1131 Alternative Minimum Tax Who is Subject ANew corporation is exempt in Year 1 AExempt in Year 2 if Year 1 sales lt5 million AExempt in Year 3 if average sales in years 1 and 2 lt 75 million AExempt in subsequent years if average gross receipts for three prior years lt 75 million AOnce a corporation fails to be exempt it is ineligible for AMT exemption for all subsequent tax years 1132 Example AMT Exemption AYear1 sales 4 million Exempt from AMT because it s year 1 AYear 2 sales 8 million Exempt because Year 1 sales lt5 million AYear 3 sales 12 million Exempt because average of years 1 and 2 6 million which is lt 75 million AYear 4 sales 2 million Subject to AMT because average of years 1 2 amp 3 8 million which is gt 75 million AThus the firm is subject to AMT in all subsequent years 1133 Alternative Minimum Tax Overview AAlternative minimum taxable income AMTI Aless Exemption A AMTI in excess of Exemption QIIlT E 122 39 Ax 20 A Tentative minimum tax TMT Aless Regular Tax A Alternative minimum tax AMT 1134 Alternative Minimum Taxable Income AMTI AStarts with regular taxable income Add AMT preferences Add or subtract AMT adjustments Subtract AMT NOL 1135 AMT Preferences APreferences are always positive additions to AMTI AExampIes Taxexempt interest income from private activity bonds municipal bonds issued to fund nongovernment activities Percentage depletion in excess of cost basis 1136 AMT Adjustments ARepresent timing differences between regular taxable income and alternative minimum taxable income will eventually reverse perhaps over several periods AExamples Differences between MACRS and ADS depreciation amounts Completedcontract method l7 Amortization of pollution control facilities ACE adjustment 1137 Application Problem 20 20 Raise s taxable income AMT adjustments AMT tax preferences AMTI before exemption Exemption AMT rate Tentative minimum tax Regular tax AMT 3590000 980000 315000 4885000 0 4885000 20 977000 1220600 0 ACE Adjustment AAdjustment equals 75 of difference between adjusted current earnings and AMTI before ACE adjustment and AMT NOL Adjusted current earnings an economic measure of earnings that approximates financial statement net income Any negative ACE adjustment ACE gt AMTI before ACE and AMT NOL limited to cumulative positive ACE adjustments from prior years 1139 AMT NOL Deduction AAMT NOL amount computed using alternative taxable income approach ADeduction limited to 90 of AMTI before the AMT NOL Example If AMTI before consideration of any NOL is 100000 the maximum allowable AMT NOL deduction is 90000 1140 Application Problem 21 Grand s taxable income before NOL deduction 1250000 AMT adjustments 0 AMT tax preferences 0 AMTI before NOL deduction and exemption 1250000 Exemption 0 1250000 NOL deduction 90 AMTI before deduction 1125000 125000 AMT rate 20 Tentative minimum tax 25000 Regular tax 0 AMT 25000 Grand has no taxable income after the NOL deduction AMT More Details AExemption 40000 but is reduced by 25 of the amount that AMTI exceeds 150000 AAMTI in excess of the Exemption is multiplied by 20 Tentative Minimum Tax TMT Alf TMT gt Regular tax then TMT less Regular Tax Alternative Minimum Tax AMT Alf TMT lt Regular tax AMT 0 ACorporations with modest AMT adjustments and preferences avoid AMT 1142 Application Problem 19 19 Perkin s taxable income AMT adjustments AMT tax preference AMT before exemption Exemption 40000 25 x 17000 excess AMTI AMT rate Tentative minimum tax Regular tax AMT 100000 45000 22000 167000 135750 131250 20 26250 22250 AMinimum tax credit Results when AMT is paid Reduces regular tax in subsequent year Can t reduce regular tax to less than TMT Carries forward indefinitely ACorporate AMT is not designed as a permanent tax increase but only accelerates the payment of tax A Eliminating the AMT is a frequent tax debate in the news Application Problem 23 Year 1 Year 2 Year 3 Minimum Tax Credit 40000 0 0 Generated Minimum Tax Credit 0 20000 20000 Used Final Tax 150000 130000 130000 Liability Minimum Tax Credit 40000 20000 0 Carryfonvard Distributions to investors Creditors amp Shareholders Alnterest payments are deductible while payments on stock ie dividends are nondeductible AThis creates a bias in favor of debt financing ANontax costs associated with debt financing include large cash flow commitments and a greater risk of insolvency AThe nontax costs often outweigh the tax savings associated with debt 1146 Capitalized Costs Chapter 07 ASimilar to GAAP if an expenditure creates or enhances an identifiable asset with a useful life substantially beyond the current year the expenditure must be capitalized ASome capitalized costs can be recovered through depreciation amortization or depletion deductions AA capitalized cost that is not depreciable amortizable or depletable is recovered only on disposition of the asset Expense or Capitalize Tax Subsidies Permit Expensing ARepairs and maintenance AThe tax law permits immediate expensing of certain A Expenditures that are regular and recurring in nature and capital expenditures do not materially add to either the value or the useful life A ndireet federal subsidy for taxpayers who make these of an asset are deductible taxpreferred expenditures ARepair and maintenance expense AThe distinction between a repair and a capital improvement is frequently a matter of dispute between taxpayers and the IRS AOne example is research and development RampD expenditures Alndirect federal subsidy to encourage business to engage in basic research Tax Subsidies Permit Expensing AOther examples include AAdvertising A Industry specific deductions AFarmers can deduct soil and water conservation expenditures as well as the cost of fertilizers A0 and gas producers can deduct intangible drilling and development costs DC of wells App Problem 1 a Because the cost of the survey must be capitalized to the land and is not recoverable until the land is sold its aftertax cost is 14200 539 Because the research and experimental expenditure is deductible its aftertax cost is 33562 44750 44750 x 25 O Because the advertising cost is deductible its aftertax cost is 17250 23000 23000 x 25 App Problem 1 d Because the grading cost must be capitalized to the land and is not recoverable until the land is sold its aftertax cost is 120000 e Because the grading cost is deductible preference deduction for farmers its aftertax cost is 90000 120000 120000 x 25 Tax Basis ABasis is key to calculating cash flows because taxpayers recover basis at no tax cost ATax basis unrecovered dollars represented by an asset A Every asset has a tax basis Aln most cases the initial basis of an asset is cost ACost is the FMV of cash property or services expended to acquire an asset A Includes sales tax and incidental costs relating to placing the asset in service Tax Basis and Leverage ALeverage is the use of borrowed funds to purchase assets ACost basis includes the amount of borrowed funds A Firm A used 10 of its own cash and 80 of borrowed cash to buy an asset A Firm A s cost basis is 90 Alnterest paid on borrowed funds is deductible App Problem 2 a 6866 cost basis 5950 purchase price 416 sales tax 500 incidental cost b169600 cost basis FMV of stock exchanged for inventory c 7000 cost basis FMV of services exchange for machinery d20000 cost basis Cost of Goods Sold ACalculating cost of goods sold Beginning inventory Capitalized costs Inventory available for sale Ending inventoLy Cost of goods sold ACapitalized costs may be greater for tax than book A Unicap rules for capitalization of indirect costs overhead ATemporary unfavorable booktax difference A Reverses through cost of goods sold Discussion Problem 7 Because Corporation J s insurance premiums related to assets used in the production of inventory the unicap rules require that the premiums be capitalized to inventory rather than deducted Corporation K is a service business with no inventory Therefore its insurance premiums are period rather than product costs and can be deducted App Problem 7 Company XYZ s cost of goods sold for its first year of operations is computed as follows Book Tax Direct material cost 200000 200000 Direct labor cost 130000 130000 Indirect costs 85 000 116 000 Total cost of 1000 units 415000 446000 Cost of ending inventory 260 units 107 900 115 960 Cost of goods sold 740 units 307 100 330 040 Inventory Valuation Methods ATaXpayers may value ending inventory and cost of goods sold by using ASpecific identification method A FirstIn firstout convention FIFO ALastin firstout convention LIFO A Must be consistent with financial reporting Discussion Problem 8 In a period of inflation in which the most recently purchased goods are the most expensive the LIFO costing convention maximizes cost of goods sold and minimizes the capitalized cost of inventory Consequently the LIFO method minimizes current income which is good from a tax perspective but bad from a financial reporting perspective Firms cannot use LIFO for tax and another method for financial reporting and thus must take the good with the bad Finally International Financial Reporting Standards do not permit the use of LIFO which could preclude its use for tax purposes when US standards converge to IFRS in the future Depreciation ADepreciation applies to tangible assets that A Lose value over time due to wear and tear obsolescence ABuildings are depreciable but land is not A Have a reasonably ascertainable useful life AArtwork is not depreciable Depreciation MACRS Recovery Periods and Methods ABefore 1981 tax depreciation was based on an asset s estimated useful life Under MACRS estimated useful life is irrelevant AThe MACRS recovery period is usually shorterthan an asset s estimated useful life What affect does this have on the purchasing behavior of firms AThe shorter lives reduce the aftertax cost of the assets and acts as an incentive for firms to make capital acquisitions ADepreciation for 3 5 7 and 10year recovery property is computed underthe 200 declining balance method ADepreciation for 15 and 20year recovery property is computed underthe 150 declining balance method ADepreciation for 25 275 39 and 50year recovery property is computed underthe straightline method Depreciation Conventions for Personalty ADepreciation for 3 5 7 10 15 and 20year recovery property personalty is generally based on a halfyear convention AOnehalf year of depreciation is allowed for the year in which property is placed in service AConvention built in to IRS Tables AOnehalf year of depreciation is allowed for the year in which property is disposed of ANot built into IRS Tables A Midquarter convention applies if more than 40 of personalty acquired in a year is placed in service in the 4th quarter 719 Depreciation Convention for Realty ADepreciation for 25 275 39 and 50 year recovery property realty is based on a midmonth convention AOnehalf month of depreciation is allowed forthe month in which property is placed in service AConvention built into IRS Tables AOnehalf month of depreciation is allowed forthe month in which property is disposed of ANot built into IRS Tables Limited Depreciation for Passenger Automobiles AMaximum annual depreciation per vehicle placed in senice in 2010 2010 2060 A2011 4900 2nd year A2012 2950 3rd year A2013 1775 4th year and beyond ACompute depreciation per MACRS then apply the App Problem 9 a A land irrigation system is 15year recovery property Firstyear MACRS is 3125 62500 x 5 O39 Duplicating equipment is 5year recovery property Firstyear MACRS is 12500 62500 x 20 c An oceangoing barge is 10year recovery property Firstyear MACRS is 6250 62500 x 10 Q Small manufacturing tools are 3year recovery property Firstyear MACRS is 20831 62500 x 3333 Discussion Problem 9 The capitalized cost of a depreciable asset could be different for tax purposes than for financial statement purposes The time period over which the cost is recovered could be different The method for computing annual depreciation could be different Finally the convention for determining depreciation in the year of acquisition or disposition could be different App Problem 13 a Book depreciation is calculated as follows Cost of equipment 800000 Residual value 50 000 Depreciable basis 750000 120 months 6250 monthly depreciation Ten months x 6250 0m book depreciation App Problem 13b App Problem 13c b initial basis of equipment 800000 0 Boot Tax Cost of equipment 800000 800000 Yeari recovery percentage ioriyear MACRS 1429 Accumulated depreciation 62500 114320 MACRS deprecration 114320 Adjusted basis at beginning of next year 737 500 685 680 App Problem 4 App Problem 5 a 2010 2011 a 2010 2011 322353 501000 Cost of asset 50000 Annual depreciation x 35 1 099 saga Debt Proceeds 50000 Net cash flow 5 48 901 35 Interest expense 3800 3800 b 39t39 t b 39 50 000 Tax saVingS 39 39a s aSFS 39 Interest deduction X 35 1330 1330 Xiirsie e iis39aaf nd of 2010 35 Annual depreCiatiO X 35 1 E Year 2 depreciation 7200 Net C35h floW 1 371 i Adjusted basis at end of 2011 39660 b The use of leverage has no effect on Firm A s adjusted basis in the asset Section 179 Expensing Election Section 179 Example ATaXpayer may expense a limited amount of cost of qualifying property placed in senice in a year A Limited amount is 500000 in 2011 AQualifying property is depreciable personalty and offthe shelf software ACapitalized cost unexpensed is recovered through MACRS ALimited amount is reduced by the aggregate cost of qualifying property in excess of a threshold AThreshold is 2 million in 2011 AMayer Inc purchased 578200 of qualifying property in 2011 A Mayer may expense 500000 of the cost and capitalize 78200 as the depreciable basis of the property ALowe Inc purchased 2070000 of qualifying property in 2011 A Lowe must reduce its limited amount by 70000 2070000 2000000 threshold A Lowe may expense 430000 of the cost 500000 70000 and capitalize 1640000 as the depreciable basis of the property Taxable Income Limitation Bonus Depreciation AThe deduction for a Section 179 expense is limited to taxable business income before the deduction AAny nondeductible expense carries forward to future years Aln 2011 Boyd Inc elected to expense 112000 of the cost of qualifying property A Boyd s taxable income before any Section 179 deduction was 91800 A Boyd s Section 179 deduction is limited to 91800 A Boyd has a 20200 expense carryfonNard to 2012 A1OO bonus depreciation permits immediate expensing of 100 ofthe cost of qualifying property placed in senice after September 8 2010 and before January 1 2012 AQualifying property is M depreciable personalty computer software and certain leasehold improvements A50 bonus applies to acquisitions after December 31 2007 and before September 9 2010 App Problem 17a Total cost of depreciable personalty 780000 Section 179 election2010 dollar amount 500 000 Tax basis after 179 deduction 280000 50 bonus depreciation 140 000 Tax basis recoverable through MACRS 140000 Year1 percentage for 7year MACRS 1429 Year 1 regular MACRS depreciation 20006 Total deduction 500000 140000 20006 660 006 App Problem 17b Total cost of depreciable personalty 2200000 Section 179 election Total cost 2200000 Threshold 2 000 000 Excess cost 200000 2010 dollar amount 500000 200000 300 000 Tax basis after 179 deduction 1900000 50 bonus depreciation 950 000 Tax basis recoverable through MACRS 950000 Year 1 percentagefor 7yearMACRS 1429 Year 1 regular MACRS depreciation 135755 Total deduction 3000009500001357551 385 755 App Problem 17c Total cost of depreciable personalty 2750000 50 bonus depreciation 1 875 000 Tax basis recoverable through MACRS 1875000 Year 1 percentage for 7year MACRS property Year 1 regular MACRS depreciation 198488 Total deduction 1375000 196488 1 571 488 App Problem 17d Total cost of depreciable personalty 780000 Section 179 election2010 dollar amount M Tax basis after 179 deduction 280000 100 bonus depreciation M Tax basis recoverable through MACRS 0 C Total deduction 500000 280000 780 00 Intangible Assets Organizational and StartUp Costs Alntangible assets have no physical substance A Examples include leases patents and other contractual rights 39 AThe basis of an intangible asset is amortized on a straightline method overthe determinable life Alntangible assets with no determinable life are not amortizable AExamples include securities and partnership interests AOrganizational costs of a corporation or partnership include legal accounting and filing fees attributable to the formation of the entity AStartup costs include the cost of investigating a new business and expenses incurred before the new business is operational A Both costs are subject to the same cost recovery rule A First 5000 is deductible ADeduction reduced by any amount of cost in excess of 50000 ANondeductible costs are capitalized and amortized over 15 years App Problem 24 4 Mr and Mrs FB have 15490 startup expenditures Rent for April Commercial real estate 2100 Equipment 990 Advertising during preoperating phase 900 Staff hiring and training during preoperating phase 11 500 15 490 They can deduct 5000 of these expenditures and must capitalize the 10490 remainder They can elect to amortize the capitalized cost over 180 months at the rate of 5828 per month If they make the election they can deduct 466 amortization 8 months x 5828 on their current year tax return App Problem 24 Mr and Mrs FB can deduct the 24720 rent on the commercial real estate and restaurant equipment for May through December Acquisition intangibies Amortization of Purchased Goodwill AA firm that purchases an entire business for a AFortaX purposes the cost of purchased goodwill is i lumpsum price must allocated the cost to both I amortized over 15 years tangible and Intangible aSSEtS AFor book purposes goodwill is not amortized COSt allocation based 0 FMV f identifiable assets AAmortization deduction results in a favorable booktax AAny residual cost is allocable to purchased goodwill difference ACapitalized cost of most acquisition intangibles AF39rmS mlJSt teSt plerhased QOOdW39ll annually for including goodwill is amortized over 15 years any 39mpa39rment to 39t5 Value AAny writedown of goodwill is a nondeductible expense resulting in an unfavorable booktax difference App Problem 28 a The goodwill s cost basis is 135000 750000 Depletion purchase price 615000 FMV of recorded assets ATaXpayers recover the capitalized cost of b 135 000 180 months 750 per month I productive mines and wells through depletion amortization Underhill s firstyear deduction is Deple flon dEdUCtlon equals the greater 0f COSt 1500 2 months x 750 depletion or percentage depletion ACost depletion unrecovered basis x units of production c Underhill s book amortization for purchased SONestimated total units in the ground goodwiquot is zero Consequen y the 1500 tax A Percentage depletion statutory of gross income from deduction is a favorable difference between book the mme r We 3 and Q 05 C AAllowable even after baSIS Q 93 has been reduced to zero and taxable income At a 35 tax rate the difference results in a 525 deferred tax liability