INCOME TAXES

Taxable Income of Individuals

The amount of federal income taxes to be paid
depends on taxable income and the income tax
rates. To calculate taxable income, one must
first compute his or her gross income:
Gross income = Wages, salary, etc
+ Interest income
+ Dividends
+ Capital gains
+ Unemployment compensation
+ Other income
Taxable Income of Individuals (2)
From gross income, we substract any allowable
retirement plan contributions and other adjustments. The
result is adjusted gross income.

Adjusted Gross Income = Gross Income Adjustments.

Taxable Income = Adjusted gross income
- Personal exemption(s)
- Itemized deductions or Standard
deduction
Taxable Income of Individuals (3)
Definition:
Personal Exemptions. One exemption is provided
for each person who depends on the gross income for
his or her living.
Itemized Deduction. Some of these are:
Excessive medical and dental expenses (exceeding 7.5% of
adjusted gross income)
State and local income, property and personal property tax
Home mortgage interest
Charitable contributions
Miscellanous deductions (exceeding 2.5% of adjusted gross
income)
Taxable Income of Individuals (4)
Standard Deduction. Each taxpayer may
either itemize his or her deductions, or instead
take a standard deduction as follows:
Single taxpayers, $ 3000
Married taxpayers filling a joint return, $ 5000

Classification of Business
Expenditure
There are three distinct types of business
expenditures :
- Expenditures for depreciable assets;
- Expenditures for nondepreciable assets;
- All other business expenditures.

Taxable Income of Business Firms :
Taxable income = Gross income
- All expenditure except capital
expenditures
- Depreciation and depletion charges
Computation of Taxable Income
Example:
Tahun 1 Tahun 2 Tahun 3
Gross Income from sales $ 200 $ 200 $ 200
Purchase of special tooling
(useful life : 3 years) - 60 0 0
All other expenditures - 140 - 140 - 140
Cash results for the year $ 0 $ 60 $ 60

Compute the taxable income for each of three years ?

Example for Calculation of Taxable Income
(2)
Solution:
All other Expendiyure = $ 140

Annual depreciation charge = = $ 20

Taxable Income = 200 140 20
= $ 40
3
0 60

Computation of Individual Tax Rates
Example:
An unmarried student earned $3500 in the summer plus
another $1600 during the rest of the year. When he files an
income tax return, he will be allowed one exemption (for
himself). He estimates he spent $600 on allowable itemized
deductions. How much income tax will he pay?
Solution:
Adjustable gross income = $3500 + 1600
= $5100
Taxable income = 5100 1950 3000 = $ 150
Federal income tax = 15% x 150 = $22,5
Computation of Corporate Tax Rates
Example:
The French Chemical Corporation was formed to
produce household bleach. The firm bought land for
$220.000, had a $900.000 factory building erected, and
installed $650.000 worth of chemical and packaging
equipment. The plant was completed and operations
begun on April 1
st
. The gross income for the calendar
year was $450.000. Supplies and all operating
expenses, excluding the capital expenditures, were
$100.000. The firm will use accelerated cost recovery
system (ACRS) depreciation.
a. What is the first year depreciation charge ?
b. What is the first year taxable income?
c. How much will the corporation pay in federal income
taxes for the year?
Computation of Corporate Tax Rates (2)
Solution:
a. ACRS Depreciation:
Chemical equipmentis personal property. From Table, it
is probably in the Seven-year, all other property class.
First-year depreciation = $650.000 x 14,28%
= $ 92.820
The building is in the 31,5-year real property class. Being
placed in service April 1
st
, the appropriate
First-year depreciation = $900.000 x 2,25%
= $ 20.250
The land is a nondepreciable asset.
Total first-year ACRS depreciation = $ 92.820 + 20.250
= $ 113.070



Computation of Corporate Tax Rates (3)
b. Taxable Income
= $450.000 100.000 113.070 =
$236.930

c. Federal Income Tax
= $ 22.250 + 39%(236.930 -100.000) = $
75.653
Combined Federal and State Income Taxes
In addition to federal income taxes, most individuals and
corporations also pay state income taxes. It would be
convinient if we could derive a single tax rate to represent both
the state and federal incremental tax rates.
For an increment of income (Income),
State income taxes = ( State tax rate)(Income)
Federal taxable income= (Income)(1- State tax rate)
Federal income taxes = ( Federal tax rate)(Income)
(1- State tax rate)
The total of state and federal income taxes is
= [ State tax rate + ( Federal tax rate)(1- State tax rate)]
(Income)
Combined incremental tax rate
= State tax rate + ( Federal tax rate)(1- State tax rate)
Computation of Combined Federal and State
Income Taxes
Example:
An engineer has an income that puts him in the 28%
federal income taxes and 10% state incremental tax. He
has an opportunity to earn an extra $500 by doing a
small consulting job. What will be his combined state and
federal income tax rate on the additional income?
Solution:
Combined incremental tax rate
= 0,1 + 0,28 (1 0,1)
= 35,2 %
Economic Analysis Taking Income Taxes
Into Account
Example:
An analysis of a firms sales activities indicates that a number of
profitable sales are lost each year because the firm cannot
deliver some of its products quickly enough. By investing an
additional $20000 in inventory it is believed that the before-tax
extra profit of the firm will be $1000 higher the first year. The
second year before-tax extra profit will be $1500. Subsequent
years are expected to continue ro increase on a $500 per eyar
gradient. The investment in the additional inventory may be
recovered at the end of a four-year analysis period simply by
selling it and not replenishing the inventory. Compute:
a. The before-tax rate of return
b. The after-tax rate of return assuming an incremental tax rate
of 39%
Economic Analysis Taking Income Taxes
Into Account (2)
Cash flow table for this case :

Economic Analysis Taking Income Taxes
Into Account (3)
Before-tax rate of return:
20.000 = 1000(P/A,i,4) + 500(P/G,i,4) +
20000(P/F,i,4)
Try i = 8%,

Try i = 10%,


) 735 , 0 ( 20000 ) 65 , 4 ( 500 ) 312 , 3 ( 1000 20000
?
+ + =
20337 14700 2325 3312
?
= + + =
) 683 , 0 ( 20000 ) 378 , 4 ( 500 ) 17 , 3 ( 1000 20000
?
+ + =
19019 13660 2189 3170
?
= + + =
Economic Analysis Taking Income Taxes
Into Account (4)
Before-tax rate of return =

After-tax rate of return:
The before-tax cash flow gradient is $500. The resulting
after-tax cash flow gradient is (1-0,39)(500) = $305
20.000 = 1000(P/A,i,4) + 305(P/G,i,4) + 20000(P/F,i,4)
Try i = 5%,

i is too low
Try i = 6%,


% 5 , 8
19019 20337
20000 337 , 20
% 2 % 8 =
|
.
|

\
|

+
20173 ) 8227 , 0 ( 20000 ) 103 , 5 ( 305 ) 546 , 3 ( 610 20000
? ?
= + + =
19304 ) 7921 , 0 ( 20000 ) 4945 , 4 ( 305 ) 645 , 3 ( 610 20000
? ?
= + + =
Economic Analysis Taking Income Taxes
Into Account (5)

After-tax rate of return =

Form both computation, we can see that income taxes
influence feasibility of a business. Therefore, income
taxes must be took into account of economic
analysis.
% 2 , 5
19304 20173
20000 173 , 20
% 1 % 5 =
|
.
|

\
|

+
Estimating the After-Tax Rate of
Return
There is no shorcut method to compute the after-tax rate of
return from the before-tax rate of return. On possible
exception to this statement is in the situation of
nondepreciable assets. In this special case:
After-tax ROR = (1-Incremental tax rate)(before-tax ROR)
For previous example, we could estimate the after-tax
rate of return from the before-tax of return as follows:
After-tax ROR = (1-0,39)(8,5%)
= 5,2%