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.
At the successful completion of this lesson, students should:
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.
Reading | Read Chapter 8 of the textbook and the lesson content in this website for Lesson 8. |
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Assignment | Homework 8. |
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.
For more information you can follow these links:
Definition of Sole Proprietorship [1] (watch the videos, please)
Article on Sole Proprietorship [2]
For more information you can follow these links:
Definition of C-Corporation [4]
Article on C-Corporations [5]
For more information can be found in following this Article on S Corporations [6]
For more information you can follow these links:
Definition of Partnership [7] (watch the videos, please)
Article on Partnership [8]
For more information you can follow these links:
Video: What is a Limited Liability Company? (1:59) [9]
Article on LLCs [8]
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]
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.
Taxable Income ($) | Tax |
---|---|
$0 to $9,700 | 10% of the taxable income |
$9,701 to $39,475
|
$970 plus 12% of the excess over $9,700 |
$39,476 to $84,200 | $4,543 plus 22% of the excess over $39,476 |
$84,201 to $160,725 | $14,382 plus 24% of the excess over $84,201 |
$160,726 to $204,100 | $32,748 plus 32% of the excess over $160,726 |
$204,101 to $510,300 | $46,628 plus 35% of the excess over $204,101 |
$510,301 or more |
$153,797 plus 37% of the excess over $510,301
|
Taxable Income ($) | Tax |
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$0 to $19,400 | 10% of the taxable income |
$19,401 to $78,950 | $1,940 plus 12% of the excess over $19,401 |
$78,951 to $168,400 | $9,086 plus 22% of the excess over $78,951 |
$168,401 to $321,450 | $28,765 plus 24% of the excess over $168,401 |
$321,451 to $408,200 | $65,497 plus 32% of the excess over $321,451 |
$408,201 to $612,350 | $93,257 plus 35% of the excess over $408,201 |
$612,351 or more | $164,710 plus 37% of the excess over $612,351 |
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.
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.
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 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:
Working capital (see video definition) [29] 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) [30] 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.
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 [31], Chapter 8 [32] and Chapter 9 [33] and also at IRS, Market Segment Specialization Program, Oil and Gas Industry [34] (these resources are provided just for reference and for interested students). The most important items are summarized as:
Corporations [35]: Expense 70%, Amortize 30% over 60 months
Individuals: Expense 100%
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.
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 [36], 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.
Depreciation related to tangible property
Personal Property (general equipment): MACRS, Straight Line, Unit of Production
Real Property (generally buildings): Straight Line
Oil and Gas [37] 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 [38] 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.
The cost of acquiring and delineating the extent and quality of a resource (including recaptured exploration) form the basis for this deduction.
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 [41]) 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:
# | 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 |
- Working Capital Write-off
|
-$1,000,000
|
|||||
9 |
- Depletion Cost
|
-$240,000
|
-$240,000 | -$240,000 | -$240,000 | -$240,000 | |
|
|||||||
10 | Taxable income | -$4,560,000 | $5,092,750 | $5,578,750 | $6,585,170 | $7,643,010 |
7,580,857
|
11 | - Income tax 40% |
-$1,824,000
|
$2,037,100 | $2,231,500 | $2,634,068 | $3,057,204 | $3,032,343 |
|
|||||||
12 | Net Income |
-$2,736,000
|
$3,055,650 | $3,347,250 | $3,951,102 | $4,585,806 | $4,548,514 |
13 | + Depreciation | $357,250 | $612,250 | $437,250 | $312,250 | $781,000 | |
14 |
+ Amortization
|
$360,000 | $360,000 | $360,000 | $360,000 | $360,000 | |
15 |
+ Working Capital Write-off |
$1,000,000 |
|||||
16 |
+ Depletion Cost
|
$240,000 | $240,000 | $240,000 | $240,000 | $240,000 | |
17 |
- Mineral right acquisition cost
|
-$1,200,000 | |||||
18 |
- IDC (30%)
|
-$1,800,000
|
|||||
19 |
- Tangible producing equipment cost
|
-$2,500,000
|
|||||
20 |
- Working Capital
|
-$1,000,000
|
|||||
|
|||||||
21 | ATCF | -$8,876,000 | $4,012,900 | $4,559,500 | $4,988,352 | $5,498,056 | $6,569,514 |
So the NPV at i*=24% equals $4,508,317 and after-tax ROR will be 44.8%
Here is the explanation of how to calculate each item:
Is the 15% of the Revenue:
Equals Revenue minus Royalty
Depreciation will be according to MACRS 7 years Table A-1 at IRS website [42] (this table is for 7 years, half year convention; meaning that 7 years of depreciation starts at mid first year and continues to mid 8th year). Year 1 to year 4 is similar to table and for year 5th the remaining of the book value.
As explained above for integrated producers, 70% of IDC is eligible to be expensed.
As explained above 30% of IDC can be amortize over 60 months and example 8-1 description wants it to start from time zero
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)
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
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 [43]).
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.
Equals 40% of taxable income
Equals Taxable income minus Income tax 40%
We add back the depreciation that we deducted from income to calculate the taxable income.
We add the amortization that we deducted from income to calculate the taxable income.
We add the Working Capital Write-off that we deducted from income to calculate the taxable income.
We add the depletion cost that we deducted from income to calculate the taxable income.
The capital cost invested for mineral right acquisition cost is $1,200,000 and paid at time zero.
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.
The capital cost invested for tangible producing equipment cost is $2,500,000 and paid at time zero.
This is the capital cost that investor has to pay as Working Capital at time zero.
After-Tax Cash Flow: the summation of all values (between two horizontal lines) for each year.
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.
You have reached the end of Lesson 8! Double-check the to-do list on the Lesson 8 Overview page [44] to make sure you have completed all of the activities listed there before you begin Lesson 9.
Links
[1] http://www.investopedia.com/terms/s/soleproprietorship.asp
[2] https://www.sba.gov/content/sole-proprietorship
[3] http://www.investopedia.com/terms/d/double_taxation.asp
[4] http://www.inc.com/encyclopedia/c-corporation.html
[5] https://www.sba.gov/starting-business/choose-your-business-structure/corporation
[6] https://www.sba.gov/starting-business/choose-your-business-structure/s-corporation
[7] http://www.investopedia.com/terms/p/partnership.asp
[8] https://www.sba.gov/business-guide/launch-your-business/choose-business-structure#section-header-1
[9] https://www.youtube.com/watch?v=oLcHSBjt1L4
[10] http://www.investopedia.com/terms/m/mlp.asp
[11] http://www.investinganswers.com/financial-dictionary/commodities-precious-metals/master-limited-partnership-mlp-803
[12] https://www.irs.gov/pub/irs-pdf/i1040tt.pdf
[13] http://www.investopedia.com/terms/c/capitalgain.asp
[14] http://www.investopedia.com/terms/c/capital_gains_tax.asp
[15] https://www.irs.gov/uac/Newsroom/Ten-Facts-about-Capital-Gains-and-Losses1
[16] https://www.irs.gov/publications/p17/ch16.html
[17] https://taxfoundation.org/state-corporate-income-tax-rates-brackets-2020
[18] http://www.investopedia.com/terms/t/taxcredit.asp
[19] https://www.energy.gov/eere/solar/downloads/residential-and-commercial-itc-factsheets
[20] http://energy.gov/fe/science-innovation/oil-gas-research/enhanced-oil-recovery
[21] http://www.ipaa.org/wp-content/uploads/2016/12/2009-03-EnhancedOilRecovery.pdf
[22] http://www.law.cornell.edu/uscode/text/26/43
[23] https://www.treasury.gov/resource-center/tax-policy/Documents/Report-Investing-in-US-Competitiveness-2011.pdf
[24] https://www.irs.gov/Businesses/Research-Credit
[25] https://wayback.archive-it.org/5902/20150627200929/http%3A//www.nsf.gov/statistics/infbrief/nsf05316/
[26] http://www.afdc.energy.gov/fuels/biodiesel.html
[27] https://www.irs.gov/pub/irs-drop/n-16-05.pdf
[28] https://www.irs.gov/pub/irs-pdf/i8864.pdf
[29] https://www.youtube.com/watch?v=2yrI2sM8LhI
[30] http://www.investinganswers.com/financial-dictionary/financial-statement-analysis/working-capital-869
[31] https://www.irs.gov/publications/p535/ch07.html
[32] https://www.irs.gov/publications/p535/ch08.html
[33] https://www.irs.gov/publications/p535/ch09.html
[34] https://www.irs.gov/pub/irs-mssp/oilgas.pdf
[35] https://www.irs.gov/publications/p535/ch07.html#en_US_2014_publink1000208889
[36] http://www.irs.gov/pub/irs-mssp/oilgas.pdf
[37] https://www.irs.gov/publications/p535/ch08.html#en_US_2014_publink1000209018
[38] https://www.irs.gov/publications/p535/ch07.html#en_US_2014_publink1000208891
[39] https://www.irs.gov/publications/p535/ch09.html#en_US_2014_publink1000209035
[40] https://www.irs.gov/publications/p535/ch09.html#en_US_2014_publink1000209050
[41] https://www.irs.gov/publications/p535/ch09.html#en_US_2014_publink1000209078
[42] https://www.irs.gov/publications/p946/ar02.html
[43] http://www.investinganswers.com/financial-dictionary/tax-center/tax-loss-carryforward-4151
[44] https://www.e-education.psu.edu/eme460/node/745