The Most Taxing The Most Taxing Questions – Taxes and Questions – Taxes and Cash FlowsCash Flows© 2004 Dr. B. C. Paul© 2004 Dr. B. C. Paul

Taxes and Project AnalysisTaxes and Project Analysis Showed you how to get cash flows and compute Showed you how to get cash flows and compute

returns but do you really get the money?returns but do you really get the money? Income taxes of 32% - 36%Income taxes of 32% - 36% Sales taxes of 7%Sales taxes of 7% Property taxes of several percent of asset valuesProperty taxes of several percent of asset values An Average American usually works a little over 4 An Average American usually works a little over 4

months/year just to pay taxesmonths/year just to pay taxes We often talk of “Before” and “After” Tax AnalysisWe often talk of “Before” and “After” Tax Analysis

Rates of ReturnRates of Return

Real and NominalReal and Nominal Before tax and After taxBefore tax and After tax And of course combinations Nominal – And of course combinations Nominal –

After Tax Rate of ReturnAfter Tax Rate of Return Need to Make Sure You Are ConsistentNeed to Make Sure You Are Consistent

Doing A Cash Flow With Doing A Cash Flow With TaxesTaxes

Cash flows for Engineering Economic Analysis Cash flows for Engineering Economic Analysis are simply lists of money received and money are simply lists of money received and money spent on a time line showing when the event spent on a time line showing when the event occursoccurs

Adding Taxes to Your Cash FlowAdding Taxes to Your Cash Flow Taxes are an expense – put them on the time-line Taxes are an expense – put them on the time-line

where they occurwhere they occur

Implicit in putting Tax on the time line is that Implicit in putting Tax on the time line is that you know what the amount isyou know what the amount is

Several Types of TaxesSeveral Types of Taxes

Sales TaxesSales Taxes Charged to End User of ProductCharged to End User of Product Normally not charged on raw material inputs Normally not charged on raw material inputs

to a processto a process If make aluminum out of bauxite, bauxite is If make aluminum out of bauxite, bauxite is

normally not taxednormally not taxed Tax occurs whether or not business or Tax occurs whether or not business or

individual is making a “profit”individual is making a “profit” Ie they can make your initial negative cash flows Ie they can make your initial negative cash flows

larger, not just your later positive flows smallerlarger, not just your later positive flows smaller

Types of TaxesTypes of Taxes

Property TaxesProperty Taxes Levied on value of assets (saw some Levied on value of assets (saw some

examples with Herby and Hanna Housing)examples with Herby and Hanna Housing) Also levied whether or not business has a Also levied whether or not business has a

profitprofit Inventory TaxesInventory Taxes

Normally target retailers to get them to move Normally target retailers to get them to move goods not just sit on themgoods not just sit on them

Again levied whether or not business has a Again levied whether or not business has a profitprofit

Income TaxIncome Tax

Normally the single largest biteNormally the single largest bite Bush has tried to cut rate but can still be Bush has tried to cut rate but can still be

36%36% Historically and in some places income tax Historically and in some places income tax

can be 90%can be 90%

Extent to Which a Business pays income Extent to Which a Business pays income taxes varies with how business is set uptaxes varies with how business is set up

Common Business Common Business Arrangements Arrangements (Liability and Tax Issues)(Liability and Tax Issues)

Sole ProprietorshipSole Proprietorship This is your own business (sometimes a jointly This is your own business (sometimes a jointly

owned business with a spouse)owned business with a spouse) Husband-Wife teams may become one entity for tax Husband-Wife teams may become one entity for tax

purposespurposes

Business is handled as part of your personal tax Business is handled as part of your personal tax returnreturn Generally use a series of schedules with a 1040 long Generally use a series of schedules with a 1040 long

formform Profits and losses become part of your personal incomeProfits and losses become part of your personal income

The Sole ProprietorshipThe Sole Proprietorship

Liability IssuesLiability Issues The actions and liabilities of the business The actions and liabilities of the business

are your actions and liabilitiesare your actions and liabilities In Civil action your personal assets may be In Civil action your personal assets may be

seized to satisfy business problemsseized to satisfy business problems

Risk issuesRisk issues You must capitalize the business and You must capitalize the business and

assume all the riskassume all the risk

The PartnershipThe Partnership

Risk MitigationRisk Mitigation The capitalization and skills aspects of the The capitalization and skills aspects of the

business are split between multiple individualsbusiness are split between multiple individuals

For Tax Purposes the earnings and losses For Tax Purposes the earnings and losses of the business split to each individuals of the business split to each individuals taxes - just like a sole proprietorship only taxes - just like a sole proprietorship only earnings or losses are ratios of ownershipearnings or losses are ratios of ownership

The Partnership PerilThe Partnership Peril

Partnership is seldom used todayPartnership is seldom used today Liability problemLiability problem

The actions of any partner or the business The actions of any partner or the business become your actionsbecome your actions Including the personal debts and actions of your Including the personal debts and actions of your

partnerpartner

The CorporationThe Corporation

Incorporation causes the business to Incorporation causes the business to become a separate entity - legally and for become a separate entity - legally and for tax purposestax purposes You have no liability for the actions and You have no liability for the actions and

finances of the business (unless there was finances of the business (unless there was knowing illegal action - pierce the corporate knowing illegal action - pierce the corporate veil)veil)

Board of Directors generally are not liable Board of Directors generally are not liable and company often buys insurance for themand company often buys insurance for them

IncorporatingIncorporating

Incorporating is relatively inexpensiveIncorporating is relatively inexpensive About $50 to fileAbout $50 to file There is a lot of paperwork both to create There is a lot of paperwork both to create

and maintainand maintain Have to decide where to incorporate - Have to decide where to incorporate -

Incorporation is a State legal actionIncorporation is a State legal action have to have some sort of business presence in have to have some sort of business presence in

your state of incorporationyour state of incorporation

Taxing CorporationsTaxing Corporations A corporation fills out its own tax returns and A corporation fills out its own tax returns and

pays its own taxespays its own taxes Only distributions of earnings are a taxable Only distributions of earnings are a taxable

event for individual owners of corporationsevent for individual owners of corporations Sale of your interest in a corporation will usually Sale of your interest in a corporation will usually

create a “Capital Gains” event.create a “Capital Gains” event.

Decisions in Corporate Decisions in Corporate StructureStructure

Should Project be set up as stand alone proposition or Should Project be set up as stand alone proposition or a subsidiary of larger companya subsidiary of larger company

Tax Loss ProblemTax Loss Problem Most projects cause negative initial cash flows and lossesMost projects cause negative initial cash flows and losses Can only write off tax losses to the extent of the profitCan only write off tax losses to the extent of the profit Independent companies must carry tax loss forward (ie if they Independent companies must carry tax loss forward (ie if they

come out with a loss you move it forward as a deduction next come out with a loss you move it forward as a deduction next year)year) You don’t pay taxes that year but there is no check back from the You don’t pay taxes that year but there is no check back from the

governmentgovernment At 15% next year the deduction is only worth 85 cents on the At 15% next year the deduction is only worth 85 cents on the

dollardollar Limited to 7 years carry forward or 3 years carry backLimited to 7 years carry forward or 3 years carry back

Impact of Carry ForwardImpact of Carry Forward

Tax reductions expand bottom line cash flowTax reductions expand bottom line cash flow Carry forward delays a positive revenue event – Carry forward delays a positive revenue event –

hurts NPVhurts NPV

Carry forward can also make company a take Carry forward can also make company a take over targetover target If company has $30 worth of tax deductions carrying If company has $30 worth of tax deductions carrying

forward for every $100 of value – you are for sale forward for every $100 of value – you are for sale for 70 cents on the dollar to a large corporationfor 70 cents on the dollar to a large corporation

Corporate Subsidiary Corporate Subsidiary OptionOption

Tax books and filings are on the parent Tax books and filings are on the parent companycompany Company can use initial investments and negative Company can use initial investments and negative

cash flows as a deduction against incomecash flows as a deduction against income Moves tax benefits forward in time and sweetens the NPVMoves tax benefits forward in time and sweetens the NPV

Liability ProblemLiability Problem If something goes wrong in the subsidiary company If something goes wrong in the subsidiary company

the parent company is liablethe parent company is liable Phillip Morris and Cigarette DilemaPhillip Morris and Cigarette Dilema

Investor Returns and Investor Returns and Corporate BuisinessCorporate Buisiness

The Double Tax ProblemThe Double Tax Problem The company pays tax on its profitsThe company pays tax on its profits

Have different tax rates than individuals (often Have different tax rates than individuals (often less favorable)less favorable)

Companies after tax profits go to share Companies after tax profits go to share holders who then pay tax on the income holders who then pay tax on the income as part of their income taxas part of their income tax Money to the investor gets double dipped by Money to the investor gets double dipped by

Uncle SammyUncle Sammy

Fighting Double TaxationFighting Double Taxation Individuals who incorporate their freelance Individuals who incorporate their freelance

work use Corporation for protectionwork use Corporation for protection Paper work transfers earnings to individual as Paper work transfers earnings to individual as

wages or bonuses so corporation makes little or wages or bonuses so corporation makes little or no moneyno money

Subchapter S Corporations / TrustsSubchapter S Corporations / Trusts Corporations distribute their tax events directly Corporations distribute their tax events directly

to the share-holdersto the share-holders Share holders deal with on their own income taxShare holders deal with on their own income tax

S Type CorporationsS Type Corporations

Attempt to give people what use to be Attempt to give people what use to be possible with partnershipspossible with partnerships

Paper-work is rather restrictivePaper-work is rather restrictive Can make for nightmarish individual tax Can make for nightmarish individual tax

returnsreturns There are limits on what S Type can doThere are limits on what S Type can do

Corporate Veil may not be quite as Corporate Veil may not be quite as effectiveeffective