Overview

In this lesson, types of business organizations for tax purposes will be explained. Also, corporate and individual income tax, capital gains tax, tax credits, working capital and mining and petroleum project considerations will be reviewed.

Learning Objectives

At the successful completion of this lesson, students should:

• be able to calculate individual and corporate income tax;
• be familiar with individual and corporate capital gains tax treatment;
• demonstrate tax treatment of investment terminal (salvage) value;
• be familiar with state tax considerations; and
• distinguish between different types of tax credits.

What is due for Lesson 8?

This lesson will take us one week to complete. Please refer to the Course Syllabus for specific time frames and due dates. Specific directions for the assignment below can be found within this lesson.

Lesson 8: Reading and Assignment

Reading	Read Chapter 8 of the textbook and the lesson content in this website for Lesson 8.
Assignment	Homework 8.

Questions?

If you have any questions, please post them to our discussion forum, located under the Modules tab in Canvas. I will check that discussion forum daily to respond. While you are there, feel free to post your own responses if you, too, are able to help out a classmate.

In order to properly evaluate the economics of investment alternatives based on after tax analysis, it is required to consider all the activities related to tax and not the financial report or book. These are activities including revenue, costs, tax deductions, tax credits and so on with respect to the time that they occurred. Different types of business organizations have different tax considerations, and the person(s) who want(s) to form the business has/have to decide which type to choose. Here, we explain some of the most common business entity types for tax purposes.

Sole Proprietorship

• Sole Proprietorship is the simplest form of establishing a business.
• Sole Proprietorship is the most common structure to start a business.
• Only one person can be the owner.
• ​The owner has complete control on decisions.
• The owner collects all the profit.
• The owner is responsible and liable for all the debts, obligations, and risks.
• The business doesn’t pay tax (business entity is not taxed) separately.
• The business doesn’t have a separate entity than the owner.
• Sole Proprietorship has the lowest tax rate between business entities.

For more information you can follow these links:
Definition of Sole Proprietorship [1] (watch the videos, please)
Article on Sole Proprietorship [2]

Regular C-Corporation

• Is the most common form of business.
• Business has a separate entity.
• Owners are shareholders.
• Profits from the corporation are either retained to finance future investments, or are distributed to shareholders in the form of dividends.
• The business entity is responsible for the debts, not the owners (owners are protected).
• Shareholders are protected from personal loss.
• Double taxation [3]: Income is taxed twice: 1) Corporation pays income tax 2) After tax income distributed between shareholders (dividends) is taxed as well, at the personal level.

For more information you can follow these links:
Definition of C-Corporation [4]
Article on C-Corporations [5]

Sub Chapter S-Corporation

• Owners can convert an initially established C-Corporation to S-Corporation.
• Owners are protected similar to C-Corporation.
• Business has a separate entity.
• Just shareholders are taxed. There is no double taxation.

For more information can be found in following this Article on S Corporations [6]

Partnership

• Partnership has more than one member (partner).
• Ownership is based on partners’ portion of contribution in forms of money, property, or skill.
• Distribution of profit and financial commitments are based on ownership.
• Similar to sole proprietorships, partners are responsible for all the liabilities of the business and also other partners.
• Unlike corporations, partners are not protected and partnership doesn’t limit the liability of partners.

For more information you can follow these links:
Definition of Partnership [7] (watch the videos, please)
Article on Partnership [8]

Limited Liability Company (LLC)

• Provides limited liability for members like corporations, but organized and taxed like partnership.

For more information you can follow these links:
Video: What is a Limited Liability Company? (1:59) [9]
Article on LLCs [8]

Master Limited Partnership (MLP)

• MLP acts like a corporation and its share is publicly traded.
• Profits for the MLP, however, are distributed among the partners like a partnership or LLC. There are therefore some tax advantages to the MLP structure (MLPs typically pay no income tax).
• This corporate structure originated in the oil and gas midstream sector (pipelines) but has since expanded to the upstream (exploration and production) sector.
• Because MLPs pay out all operating profits to shareholders, they cannot recycle profits into new investments. So MLPs in growth industries are constantly in capital markets raising new funds for investments. In the oil and gas sector, a crash in commodity prices reduces the value of MLPs and makes it harder for them to raise new capital to make new investments. Please read the article (on Canvas) from The Economist, "Running on Empty," to learn more.

For more information you can follow these links:
Definition of Master Limited Partnership (MLP) [10] (watch the videos, please)
Article on Master Limited Partnership (MLP) [11]

Corporate and Individual Federal Income Tax Rates

U.S. federal tax rates for corporations and individuals is an increasing function of taxable income, meaning that the higher taxable income you have, the higher federal tax rate you will have as a corporation or individual. U.S. federal income tax rate varies each year, depending on the monetary policies. The following tables include the rates and calculations.

Table 8-1: U.S. federal tax rates for unmarried individuals in 2024 (source: IRS: 1040tt [12])

Taxable Income ($)	Tax
$0 to $11,600	10% of the taxable income
$11,601 to $47,150	$1160 plus 12% of the excess over $11,600
$47,151 to $100,525	$5,426 plus 22% of the excess over $47,150
$100,526 to $190,950	$17,168.5 plus 24% of the excess over $100,525
$191,951to $243,725	$39,110.5 plus 32% of the excess over $190,950
$243,726 to $609,350	$55,678.50 plus 35% of the excess over $243,725
$609,351 or more	$183,647.25 plus 37% of the excess over $609,350

Corporate and Individual Capital Gains Tax Treatment

Current tax law continues to make a distinction between capital [13]and ordinary gains and losses. Corporations and individuals alike must compute the appropriate long-term and short-term gains and losses for taxes [14], however, all corporate net capital gain continues to be treated as ordinary income subject to the appropriate corporate income tax. However, corporate capital losses can only be used against corporate capital gains and further can only be carried forward five years or back three years.
Please read the brief explanation of Ten Facts about Capital Gains and Losses [15] provided by IRS. More detailed information can be found at Reporting Gains and Losses [16] by IRS.

Tax Treatment of Investment Terminal (Salvage) Value

Whenever an asset such as land, common stock, buildings, or equipment is sold by individuals or corporations, the sale value (terminal value) is compared to original cost, or remaining tax book value of depreciable, depletable, amortizable, or non-deductible asset costs to determine gain or loss. If the sale results in a gain, tax must be paid on the gain. If the sale results in a loss, the loss is deductible under the tax rules governing the handling of ordinary deductions and capital loss deductions. All long-term capital gains are taxed at the ordinary income tax rates for corporations and at applicable long-term capital gains tax rate for individuals, so it is still necessary to compare whether ordinary gain or loss, or long-term capital gain or loss is realized.

State Tax

For individuals and corporations, state income tax calculations vary greatly with some states using fixed rates, while others impose incremental rates which may be based on the equivalent of federal taxable income before state income taxes or adjusted measures of value. For corporations, Colorado, Illinois, Indiana, Massachusetts, Michigan, and Pennsylvania employ a flat tax rate on applicable state taxable income while other states have no state income tax at all, including Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. The following link displays a comparison for State Corporate Income Tax Rates in 2020 [17].

The government gives tax credit [18] to some businesses as an incentive, which can be deducted directly from tax that they have to pay. There are two main types of tax credit including Investment Tax Credit and Business Tax Credit.

Energy Credits

Energy credits or Business Energy Investment Tax Credit (ITC) are tax credits that are given to specified sectors in the energy industry to incentivize the investment. These sectors include Solar, Small Wind Turbines, Geothermal Systems, Microturbines, and Combined Heat and Power (CHP). Please read: Business Energy Investment Tax Credit (ITC) [19], provided by the U.S. Department of Energy.

Some of other business activities that can be eligible for tax credit are:

• Enhanced Oil Recovery: for more information, please follow
  • Department of Energy, Enhanced Oil Recovery [20]
  • Legal Information Institute, Enhanced Oil Recovery [21]
• Research and Experimentation Credit: for more information, please follow
  • Department of Treasury, Investing in U.S. Competitiveness [22]
  • IRS, Research Credit [23]
  • InfoBrief, The U.S. Research and Experimentation Tax Credit in the 1990s [24]
• Bio Diesel Fuels Credit: for more information, please follow
  • Department of Energy, Alternative Fuels Data Center [25]
  • Biodiesel Income Tax Credit [26]
  • IRS, 2020 Form 8864 [27]

Working capital (see video definition) [28] is the money that a company requires for day-to-day needs, and in general:

Working Capital = Current Assets - Current Liabilities

Equation 8-1

The positive value of working capital (see another definition) [29] represents the financial health of the business. Working capital is normally comprised of money required for raw material inventory, in-process materials inventory, product inventory, accounts receivables, and ready cash. For evaluation purposes, working capital generally is considered to be put into a project at the start of a business or production operation and to be fully recovered at the end of the project life when inventories are liquidated. Working capital is not allowable as tax deduction in the year it is incurred so it often has a very negative effect on project economics. Working capital cost may not be expensed, depreciated, amortized, or depleted until inventory assets are actually used or put into service. Working Capital represents the capital cost required to generate raw material inventories, in-process inventories, product inventories, and parts and supplies inventories. As inventories are used and product sold, working capital cost items become allowable tax deductions as operating costs through the cost of goods sold calculation. However, as inventory items are used, they typically are replaced so inventories are maintained at a similar level over the project life. If significant increases or decreases in working capital are projected to occur from year to year, positive or negative working capital costs can be accounted for from year to year in project analysis.

In the cash flow table of a project, working capital is generally treated as a cost at the beginning. When working capital is recovered at the end of the project, it will be added as tax-free income, since it is the return of this capital, not revenue generated by this capital, after liquidation or consumption of inventories. If only a portion of the working capital can be recovered, it will incur a real cash loss. This loss cannot be claimed as a tax-deductible expense. For more examples, see Chapter 8.10 of the textbook.

Cash flow calculations for a mining and petroleum project are similar to other businesses. The only difference is adding some tax deductions. Some of these tax deductions are mentioned in Lesson 7. More detailed information can be found at IRS Publication 535 (2019), Business Expenses under Chapter 7 [30], Chapter 8 [31] and Chapter 9 [32] and also at IRS, Market Segment Specialization Program, Oil and Gas Industry [33] and also Oil and Gas Audit Technique Guide [33] (these resources are provided just for reference and for interested students). The most important items are summarized as:

Mine Development

Corporations [34]: Expense 70%, Amortize 30% over 60 months
Individuals: Expense 100%

Mine Exploration

Corporations: Expense 70%, Amortize 30% over 60 months
Individuals: Expense 100%
Both investors are subject to a recapture provision in the event that property is deemed to be economically viable and developed.

Petroleum Intangible Drilling Costs (IDC’s)

Integrated Producers: Expense 70%, Amortize 30% over 60 months
Non-integrated producers: Expense 100%
Dry hole costs may be expensed in the year incurred by all investors

According to IRS [33], An integrated oil company is a producer which is also either a retailer, which sells more than $5 million of oil or gas in a year, or a refiner, which refines more than 50,000 barrels of oil on, any day during the year.

Capitalization of Costs: to charge a cost to a project and deduct over time

Depreciation related to tangible property
Personal Property (general equipment): MACRS, Straight Line, Unit of Production
Real Property (generally buildings): Straight Line

Amortization related to Intangible Property

Oil and Gas [35] Geological and Geophysical Costs:
Non-integrated, 24 months;
Integrated, 84 months: half-year deduction in first year for all producers;
No write-off if the asset is sold or abandoned prior to the end of the prescribed amortization period.
30% Corporation [36] Mine Development, 60 months
30% Integrated IDCs, 60 months

First year amortization deduction is generally proportional to month the asset goes into service. For qualifying oil and gas G&G, “the first year deduction is based on the mid-point of the tax year the expenses were paid or incurred.” -Tax Code Section 167(h)(1) and (h)(2). Therefore, a half-year deduction is to be considered for this class of expenditures.

Depletion: deduction unique to the resource industries

Cost Depletion of Mining [37]

The cost of acquiring and delineating the extent and quality of a resource (including recaptured exploration) form the basis for this deduction.

Cost Depletion of Oil and Gas [38]

Generally, the costs of acquiring an oil and gas lease (lease bonus, surveying, legal) are deducted by cost depletion. Geological and geophysical costs related to the property are deducted separately by amortization over a 24-month period for non-integrated producers, and 84 months for integrated companies.

Percentage Depletion based on an applicable percentage (table [39]) of the net revenue (gross revenue less royalties and, in some cases, certain transportation charges).

Note that for all producers, the costs associated with product produced and sold in a tax year are generally deductible in full. These costs include labor, overhead on labor, materials, parts, and supplies for product produced and sold and most excise taxes, sales taxes, ad valorem taxes, and related expenditures.

Example 8-1: An integrated petroleum company is planning to invest in acquiring and developing an oil reserve with the following considerations:

• Total producible oil in the reserve is estimated to be 1,000,000 barrels.
• Project life is 5 years and after reserve will be depleted.
• Production rate will be 200,000 barrels of oil per year for these 5 years.
• Mineral rights acquisition cost for property would be $1,200,000 at time zero.
• Intangible drilling cost (IDC) is expected to be $6,000,000 at time zero.
• Tangible equipment cost (producing equipment, gathering lines, and well completion and so on) is $2,500,000 at time zero.
• Working capital of $1,000,000 also at time zero, and will be 100% recovered in year 5.
• Equipment depreciation will be based on MACRS 7-years life depreciation starting from year 1.
• Write off the remaining equipment book value at year 5.
• The production selling price is assumed $40 per barrel which has 12% escalation each year starting from year 2.
• Operating cost is $750,00.0 annually with escalation rate of 10% starting from year 2.
• Income tax is 40%
• Royalty 15%.
• Amortization of IDC starts from time zero.
• Minimum After-tax rate of return is 24%.

Example 8-3

#	Year	0	1	2	3	4	5
1	Revenue		$8,000,000	$8,960,000	$10,035,200	$11,239,424	$12,588,155
2	- Royalty		-$1,200,000	-$1,344,000	-$1,505,280	-$1,685,914	-$1,888,223
3	Net Revenue		$6,800,000	$7,616,000	$8,529,920	$9,553,510	$10,699,932
4	- Operating cost with 10% esc.		-$750,000	-$825,000	-$907,500	-$998,250	-$1,098,075
5	- Depreciation (Tangible producing equipment)		-$357,250	-$612,250	-$437,250	-$312,250	-$781,000
6	- IDC (Expense 70%)	-$4,200,000
7	- Amortization of IDC (30% over 60 months)	-$360,000	-$360,000	-$360,000	-$360,000	-$360,000
8	- Depletion Cost		-$240,000	-$240,000	-$240,000	-$240,000	-$240,000
9	Taxable income	-$4,560,000	$5,092,750	$5,578,750	$6,585,170	$7,643,010	8,582,857
10	- Income tax 40%	-$1,824,000	$2,037,100	$2,231,500	$2,634,068	$3,057,204	$3,432,343
11	Net Income	-$2,736,000	$3,055,650	$3,347,250	$3,951,102	$4,585,806	$5,148,514
12	+ Depreciation		$357,250	$612,250	$437,250	$312,250	$781,000
13	+ Amortization	$360,000	$360,000	$360,000	$360,000	$360,000
14	+ Depletion Cost		$240,000	$240,000	$240,000	$240,000	$240,000
15	- Mineral right acquisition cost	-$1,200,000
16	- IDC (30%)	-$1,800,000
17	- Tangible producing equipment cost	-$2,500,000
18	- Working Capital	-$1,000,000					$1,000,000
19	ATCF	-$8,876,000	$4,012,900	$4,559,500	$4,988,352	$5,498,056	$7,169.514

So the NPV at i*=24% equals $4,712,982 and after-tax ROR will be 45.4%

Here is the explanation of how to calculate each item:

Item 1: Revenue with 12% esc.

$$\begin{array}{l}Annualproduction*price*{\left(1+escalationrate\right)}^{(n-1)}\\ Year1:200,000*40=\$8,000,000\\ Year2:200,000*40*\left(1+0.12\right)=\$8,960,000\\ Year3:200,000*40*{\left(1+0.12\right)}^2=\$10,035,200\\ Year4:200,000*40*{\left(1+0.12\right)}^3=\$11,239,424\\ Year5:200,000*40*{\left(1+0.12\right)}^4=\$12,588,155\end{array}$$

Item 2: Royalty

Is the 15% of the Revenue:

$$\begin{array}{l}Year1:8,000,000*0.15=\$1,200,000\\ Year2:8,960,000*0.15=\$1,344,000\\ Year3:10,035,200*0.15=\$1,505,280\\ Year4:11,239,424*0.15=\$1,685,913.6\\ Year5:12,588,154.88*0.15=\$1,888,223.232\end{array}$$

Item 3: Net Revenue

Equals Revenue minus Royalty

Item 4: Operating cost with 10% esc.

$$\begin{array}{l}Year1:750,000\\ Year2:750,000*\left(1+0.10\right)=825,000\\ Year3:750,000*{\left(1+0.10\right)}^2=907,500\\ Year4:750,000*{\left(1+0.10\right)}^3=998,250\\ Year5:750,000*{\left(1+0.10\right)}^4=1,098,075\end{array}$$

Item 5: Depreciation (Tangible producing equipment)

Depreciation will be according to MACRS 7 years Table A-1 at IRS website [40] (this table is for 7 years, half year convention; meaning that 7 years of depreciation starts at mid first year and continues to mid 8^th year). Year 1 to year 4 is similar to table and for year 5^th the remaining of the book value.

$$\begin{array}{l}Year1:0.1429*2,500,000=\$357,250\\ Year2:0.2449*2,500,000=\$612,250\\ Year3:0.1749*2,500,000=\$437,250\\ Year4:0.1249*2,500,000=\$312,250\\ Year5:2,500,000-\left(357,250+612,250+437,250+312,250\right)=\$781,000\end{array}$$

Item 6: IDC (Expense 70%)

As explained above for integrated producers, 70% of IDC is eligible to be expensed. $Year0:6,000,000*0.7=4,200,000$

Item 7: Amortization of IDC (30% over 60 months)

As explained above 30% of IDC can be amortize over 60 months and example 8-1 description wants it to start from time zero
$$\begin{array}{l}Year0:6,000,000*0.3*12/60=\$360,000\\ Year1:6,000,000*0.3*12/60=\$360,000\\ Year2:6,000,000*0.3*12/60=\$360,000\\ Year3:6,000,000*0.3*12/60=\$360,000\\ Year4:6,000,000*0.3*12/60=\$360,000\end{array}$$

Item 8: Working Capital Write-off

Non-cash deduction of Working Capital investment will be on year 5.

Note that Working Capital comes in three places in the table:
- Last year: before tax calculation with negative sign (item 8)
- Last year: after tax calculation with positive sign (item 15)
- Year 0: after tax calculation with negative sign (item 20)

Item 9: Depletion Cost

Depletion Cost, since the production in each year is constant and 1/5 of total available oil
Depletion Cost for each year = 1/5* Mineral right acquisition cost

$$\begin{array}{l}Year1:1,200,000*1/5=\$240,000\\ Year2:1,200,000*1/5=\$240,000\\ Year3:1,200,000*1/5=\$240,000\\ Year4:1,200,000*1/5=\$240,000\\ Year5:1,200,000*1/5=\$240,000\end{array}$$

Item 10: Taxable income

Equals the summation of all values for each year.

Note that we have -$4,560,000 tax deduction at year zero, there are two approaches here:
First, we can carry it to following years and deduct this tax deduction from taxable income in later years (loss forward [41]).
Second, we can treat it as negative tax (which intuitively implies income). Note that the earlier we receive this money the better tax benefits we have and it will be better for the economics of the project. But you should always clearly mention which technique you are using in your analysis. Here, we assume the negative taxable income causes negative tax at year zero.

Item 11: Income tax 40%

Equals 40% of taxable income

Item 12: Net Income

Equals Taxable income minus Income tax 40%

Item 13: Depreciation

We add back the depreciation that we deducted from income to calculate the taxable income.

Item 14: Amortization

We add the amortization that we deducted from income to calculate the taxable income.

Item 15: Working Capital Write-off

We add the Working Capital Write-off that we deducted from income to calculate the taxable income.

Item 16: Depletion Cost

We add the depletion cost that we deducted from income to calculate the taxable income.

Item 17: Mineral right acquisition cost

The capital cost invested for mineral right acquisition cost is $1,200,000 and paid at time zero.

Item 18: IDC (30%)

Is the remaining of the IDC that has to be invested at time zero. Remember from above, 70% of IDC is permitted to be expensed as tax deduction.
$Timezero:6,000,000*0.3=\$1,800,000$

Item 19: Tangible producing equipment cost

The capital cost invested for tangible producing equipment cost is $2,500,000 and paid at time zero.

Item 20: Working Capital

This is the capital cost that the investor has to pay as Working Capital at time zero, and recovers 100% in year 5. Note that it has no impact on tax calculation (expenditure in year 0 is not deductible, and the return in year 5 is not taxable).

Item 21: ATCF

After-Tax Cash Flow: the summation of all values (between two horizontal lines) for each year.

Summary

In this lesson, the effects of income tax on individuals and corporations in the natural resource industries are discussed. These effects vary widely from one investment alternative to another, and generally, it is imperative to compare the relative economics of investment on an after-tax basis. Income tax, both federal and state if applicable, are project costs, just as labor, materials, utilities, property taxes, borrowed money, interest, and insurance.

Working capital is the money necessary to operate a business on a day-to-day basis. It is normally comprised of money required for raw material inventory, in-process materials inventory, product inventory, accounts receivable, and ready cash. When evaluating a geo-resource project, working capital generally is considered to be put into a project at the start of a business or production operation, and to be fully recovered at the end of the project life when inventories are liquidated.

Certain mining/petroleum projects are eligible for special investment tax credits. These credits are "Energy Credits," "Enhanced Oil Recovery," "Research & Experimentation Credit," and "Bio-Diesel Fuels Credit."

After introducing the income tax, the after-tax analysis of mining the petroleum project is also covered in this lesson. The unique feature about discounted cash flow analysis of mining or petroleum projects compared to non-mineral projects is the handling of certain tax deductions.

Reminder - Complete all of the Lesson 8 tasks!

You have reached the end of Lesson 8! Double-check the to-do list on the Lesson 8 Overview page [42] to make sure you have completed all of the activities listed there before you begin Lesson 9.