Principles of Taxation

1
Principles of Taxation

• Chapter 6Property Acquisitions and Cost Recovery
  Deductions

2
Objectives

• Expense versus capitalize.
• Define tax basis and adjusted basis.
• Show how leverage reduces the after-tax cost of
  assets.
• Compute cost of goods sold.
• Use recovery period, method and convention to
  compute MACRS depreciation.
• Explain the limited expensing election.
• Understand role of depreciation in NPV of
  after-tax cash flows.
• Amortize intangibles, deplete resources.

3
Expense vs. Capitalize

• Deduction permitted for all ORDINARY AND
  NECESSARY business expenses.
• Deduction prohibited for PERMANENT improvements
  to increase the value of property.
• Some types of capitalized costs can be recovered
  through amortization or depreciation.

4
Expense vs. Capitalize

• Repairs and maintenance? Source of IRS dispute
  due to facts.
• Are environment cleanup and prevention costs
  expensed or capitalized?
• Capitalize expenditures that increase the
  _________ or _______ ______ of an asset.

5
Tax Subsidies Permit Expensing

• RD expenses (this is BIG).
• Allowing deduction for RD is a tax subsidy.
  What is the GAAP rationale for requiring expense
  under SFAS 2?
• Y2K costs - IRS has ruled these can be expensed.
• Various oil and gas IDC, depletion
• The IRS allows deductions for advertising. Why
  might this be considered an asset in the absence
  of specific allowance?

6
Tax Basis

• Tax basis unrecovered cost.
• Starting basis generally equals COST basis
• original purchase price, or
• _________ of asset if cost more difficult to
  measure.
• When do you recover the cost? Depreciation or
  sale. Example For depreciable equipment,
  adjusted basis is the original basis reduced by
  depreciation. You can think of adjusted basis as
  being the tax equivalent of net book value of
  the asset, but with tax depreciation instead of
  book depreciation.

7
Tax Basis and Leverage

• If you buy an asset with 500 cash and 4500
  debt, what is the cost basis?
• Deductions for interest and cost recovery
  (depreciation) can improve NPV of after-tax cash
  flows. AP1, 2
• Study example in text regarding After-Tax Cost of
  Leveraged Purchase. Note especially the footnote
  describing the effect of borrowing rate versus
  internal discount rate.
• Tax deductions made some leveraged tax shelters
  in early 1980s had positive NPV even when
  pre-tax flows were breakeven or negative.
  Chapters 9 and 15 will discuss limits on such tax
  shelter losses.

8
Cost Recovery

• Cost of goods sold
• Depreciation
• Amortization
• Depletion

9
Cost of goods sold

• Similar to GAAP
• 1) Beginning inventory
• 2) PLUS_____________
• 3) inventory available for sale
• 4) MINUS_________ ____________
• 5) CGS
• Tax versus GAAP differences may occur in
  capitalization of indirect costs. Tax requires
  uniform capitalization under Section 263. AP4

10
Cost of Goods Sold

• Uniform capitalization rules (IRC Section 263)
• What indirect costs must be capitalized?
• Examples? Officers comp (VP Mfg.), employee
  benefits, building rent, insurance,
  depreciation.Why might there be book-tax
  differences in indirect costs being capitalized?

11
Cost of Goods Sold

• What are permissible inventory methods? Which
  ones require book-tax conformity?
• 1
• 2
• 3
• Which method requires book-tax conformity?
• In times of inflation, LIFO reduces book and
  taxable income.

12
Depreciation

• Depreciation applies to tangible assets (things
  you can touch, versus intangibles like patents,
  goodwill) that
• lose value over time due to wear and tear,
  obsolescence.
• Does this rule make sense for real estate?
• have a reasonably ascertainable__________
  _________.
• What do you think about artwork?

13
Depreciation

• MACRS - Modified Accelerated Cost Recovery System
• Fixed recovery methods and periods
• Personalty and other short-lived property
• DDB 3, 5, 7, 10
• 150 DB15, 20
• Realty SL method _____ years residential,
  _____ years non-residential (specialty realty 20,
  25, 50).

14
Depreciation Conventions - Personalty

• Table 6-2 incorporates a half-year convention -
  provides only 1/2 of the regular rate in the year
  the property is put in service.
• When dispose of asset, multiply table amount by
  1/2 in the year of sale.
• Buy 10,000 of 7-year property in 1997. Sell the
  property in 1999. What is 1997, 1998 and 1999
  depreciation?

15
Depreciation Conventions - Personalty

• Exception to mid-year convention
• IF gt _____ personalty is acquired during the
  last quarter of the year, THEN
• Compute depreciation separately for EACH
  quarters acquisition.
• See the MID-QUARTER tables. (Instructor hand out
  in class.) ONLY adjust table amounts in year of
  disposition.
• AP6, TPC 1.

16
Depreciation Conventions - Realty

• Mid-month convention. Get 1/2 of a month in month
  acquired. Built into Table 6-3. Choose column
  for month put in service. Use this same column
  throughout the asset life. AP10.
• Like personalty, you have to adjust table amount
  in year of disposition. Get _____ of a month for
  the month of disposition.
• Buy apartment building for 1,000,000 in August
  1995. Sell in March 1999. What is depreciation
  in 1995 - 1999?

17
Depreciation Conventions

• What is the purpose of the half-year, midquarter
  and midmonth conventions?
• Balance 1) prevent taxpayer from claiming a full
  year of depreciation if hold only for a portion
  of the year against
• 2) Easier rules than computing actual days held.

18
Expensing Election

• Applies to tangible personalty.
• 2001 amount _________. See AP8.
• Limits
• Expense cannot create a__________ .
• Expense reduced for if purchases gt
  __________. AP9.
• Reduces record keeping, benefit for small
  businesses.
• Planning - if buy a 3-year, 5-year and 7-year
  asset, which one should you expense?

19
Other Depreciation Details Not in Text

• Combination business and personal use property -
  listed property - such as computers, phones,
  cars. Only use accelerated depreciation if
  business use gt 50.
• Cars have additional depreciation limits per
  year.
• Different depreciation methods apply for
  Alternative Minimum Tax purposes (Chapter 10, 14).

20
Lease versus Buy

• Example in text compares purchasing for cash
  up-front to an operating lease.
• Tax rules are similar to financial rules for
  determining whether a lease is capital or
  ordinary. A capital lease is treated like a
  purchase by the lessee.
• A lessee who obtains assets through an operating
  lease
• gives up interest and depreciation deductions
  (because lessor still owns the asset), but
• doesnt have deemed debt on financial balance
  sheet.

21
Amortization of Intangibles

• Generally requires a determinable useful life.
• Organizational costs are amortizable straight
  line method over ____ months.
• Start-up costs are also amortizable straight line
  method over ____ months - some exceptions.
• Expansion costs may be currently deductible.

22
Leasehold Costs and Improvements

• Cost of acquiring lease is amortized over the
  period of _______ .
• Improvements to leased property are capitalized
  and depreciated according to type of property.
  What do you suppose happens when lease ends?

23
Purchased Intangibles

• Allocate lump-sum price to assets by relative
  FMVs.
• Residual goodwill.
• Tax ____ years SL, GAAP ____ years SL.
  Book-tax difference is temporary under current
  tax laws.

24
Depletion

• Cost depletion ___________ __________ /
  ___________________.
• Percentage depletion
• statutory of gross income. See Q18.
• Deduct the greater of cost or percentage
  depletion.

25
Review - Book-Tax Differences

• Temporary differences due to Depreciation,
  inventory methods, goodwill amortization. (This
  used to be permanent before 1992 when goodwill
  was not amortizable for tax.)
• AP11.
• Permanent differences due to depletion (in
  excess of cost).