Doing TaxesDoing Taxes

©2004 Dr. B. C. Paul©2004 Dr. B. C. Paul

ExampleExample

Partly Poopers Inc (A division of Badish Partly Poopers Inc (A division of Badish Petroleum) runs a private sewerage treatment Petroleum) runs a private sewerage treatment facility for the town of Smarterville. Their facility for the town of Smarterville. Their unique process digests the organic stuff in the unique process digests the organic stuff in the sewerage to make natural gas, gasoline, and a sewerage to make natural gas, gasoline, and a yellow soda called Mountain Doodo. They also yellow soda called Mountain Doodo. They also mine industrial minerals out of limestone and mine industrial minerals out of limestone and then backfill the underground openings with the then backfill the underground openings with the solids (crap?) left over from their digestion solids (crap?) left over from their digestion process.process.

This year they have the This year they have the following Incoming Cash following Incoming Cash FlowsFlows

Poop processing charges to Smarterville - Poop processing charges to Smarterville - $900,000$900,000

Sale of Land with depleted mineral reserves Sale of Land with depleted mineral reserves and backfilled with all kinds of – well you know and backfilled with all kinds of – well you know what.what. $400,000$400,000

Sale of Old WW equipment $1,100,000Sale of Old WW equipment $1,100,000 Natural Gas Sales $1,400,000Natural Gas Sales $1,400,000 Gasoline Sales $1,000,000Gasoline Sales $1,000,000 Mountain Doodo $1,200,000Mountain Doodo $1,200,000 Mineral Sales $1,500,000Mineral Sales $1,500,000

Task #1 Separate The Task #1 Separate The Income and Capital Gains Income and Capital Gains Revenue StreamsRevenue Streams

IncomeIncome Poop Processing $900,000Poop Processing $900,000 Natural Gas Sales $1,400,000Natural Gas Sales $1,400,000 Gasoline Sales $1,000,000Gasoline Sales $1,000,000 Mountain DoDo $1,200,000Mountain DoDo $1,200,000 Limestone $1,500,000Limestone $1,500,000 Total Gross Income $6,000,000Total Gross Income $6,000,000

Capital Gains CategoryCapital Gains Category Used equipment $1,100,000Used equipment $1,100,000 Land $400,000Land $400,000 Total Income in Capital Gains Area $1,500,000Total Income in Capital Gains Area $1,500,000

Partly Poopers Outgoing Partly Poopers Outgoing Cash FlowCash Flow

Personnel $600,000Personnel $600,000 Utilities $250,000Utilities $250,000 Royalties on Limestone $70,000Royalties on Limestone $70,000 New Equipment for Plant $1,700,000New Equipment for Plant $1,700,000 Property Taxes to County $90,000Property Taxes to County $90,000 Insurance $65,000Insurance $65,000 Bought new land $800,000Bought new land $800,000 New CO2 well $195,000New CO2 well $195,000 Materials Handling Solids $300,000Materials Handling Solids $300,000 Mining Costs for Limestone $345,000Mining Costs for Limestone $345,000 Mine Development workings $250,000Mine Development workings $250,000 Interest on Loans $500,000Interest on Loans $500,000

Task #2 – Separate Out Task #2 – Separate Out Things that Can be Things that Can be ExpensedExpensed

Personnel $600,000Personnel $600,000 Utilities $250,000Utilities $250,000 Royalties $70,000Royalties $70,000 Property Tax $90,000Property Tax $90,000 Insurance $65,000Insurance $65,000 Materials Handling $300,000Materials Handling $300,000 Mining $345,000Mining $345,000 Interest on Loans $500,000Interest on Loans $500,000

Our Problem ChildrenOur Problem Children

Land $800,000Land $800,000 CO2 Well $195,000CO2 Well $195,000 New Equipment $1,700,000New Equipment $1,700,000 Mine Development Workings $250,000 Mine Development Workings $250,000

Items that go to Items that go to DepreciationDepreciation

New Equipment $1,700,000New Equipment $1,700,000

What About the LandWhat About the Land

$800,000 for Land$800,000 for Land Land is not expensible or depreciableLand is not expensible or depreciable Issue here is that the Land came with mineral Issue here is that the Land came with mineral

rights which Partly Poopers will userights which Partly Poopers will use Have to separateHave to separate Lets suppose $600,000 for landLets suppose $600,000 for land

Capital Asset – no immediate tax impactCapital Asset – no immediate tax impact

$200,000 for mineral rights$200,000 for mineral rights Mineral Rights will go into cost basis for DepletionMineral Rights will go into cost basis for Depletion

The Well ProblemThe Well Problem

We have $195,000 in a gas wellWe have $195,000 in a gas well Well drilling costs can be site prep, set-up, operation Well drilling costs can be site prep, set-up, operation

of drillingof drilling These are called intangible drilling costsThese are called intangible drilling costs Because they are essentially used up as you go they can Because they are essentially used up as you go they can

bebe Expensed (the usual)Expensed (the usual) Can elect to put them in cost basis for depletion (seldom Can elect to put them in cost basis for depletion (seldom

done)done)

Some aspects of drilling create hard tangible assetsSome aspects of drilling create hard tangible assets Pumps, pipes etc.Pumps, pipes etc. Depreciated over 5 years by DDB switching to SLDepreciated over 5 years by DDB switching to SL

Splitting up the Well CostSplitting up the Well Cost

Suppose 70% intangible, 30% tangibleSuppose 70% intangible, 30% tangible $136,500 can be expensed$136,500 can be expensed $58,500 capitalized$58,500 capitalized

This means we will be adding $136,500 This means we will be adding $136,500 to our Expenses Listto our Expenses List

We Also Will at $58,500 to our We Also Will at $58,500 to our Depreciation ListDepreciation List

The Mine Development The Mine Development ExpensesExpenses

Some costs actually producing rockSome costs actually producing rock These are an expense for the productThese are an expense for the product

Also need to develop tunnels or other such Also need to develop tunnels or other such development to get accessdevelopment to get access This development may serve the operation for yearsThis development may serve the operation for years

Pre-production development is subject to a Pre-production development is subject to a choice (just like Intangible Drilling Costs)choice (just like Intangible Drilling Costs) Can expense themCan expense them

If you do y ou recapture from DepletionIf you do y ou recapture from Depletion Can depreciate them by unit of productionCan depreciate them by unit of production

In this case I’m going to In this case I’m going to ExpenseExpense

Added to My Expenses areAdded to My Expenses are $136,500 in intangible drilling costs$136,500 in intangible drilling costs $250,000 in preproduction development$250,000 in preproduction development

Total Expenses $2,606,500Total Expenses $2,606,500

Moving My Income Tax Moving My Income Tax Calculation ForwardCalculation Forward

Income $6,000,000Income $6,000,000 Minus Expenses $2,606,500Minus Expenses $2,606,500 Subtotal $3,393,500Subtotal $3,393,500

Now We Get Ready for Now We Get Ready for Our Funny Money Our Funny Money DeductionsDeductions

DepreciationDepreciation AmortizationAmortization DepletionDepletion

The Capitalized The Capitalized DeductionsDeductions

$1,700,000 worth of equipment$1,700,000 worth of equipment Assume classed as Waste Water Treatment PlantAssume classed as Waste Water Treatment Plant

MACRS has 15 year lifeMACRS has 15 year life Depreciation is 150% declining balance switching to Depreciation is 150% declining balance switching to

straight linestraight line Assuming Mid Year ConventionAssuming Mid Year Convention

Year 1 depreciation is 5%Year 1 depreciation is 5%

We fill out forms to capitalizeWe fill out forms to capitalize We calculate a depreciation deduction of 5%We calculate a depreciation deduction of 5%

1,700,000 * (0.05) = $85,0001,700,000 * (0.05) = $85,000

The Tangible Well PartsThe Tangible Well Parts

$58,500$58,500 5 year Depreciation5 year Depreciation Midyear convention 10% 1rst yearMidyear convention 10% 1rst year

$5,850 deduction$5,850 deduction

Past Items DepreciationPast Items Depreciation

Suppose that the original plant cost Suppose that the original plant cost $11,000,000 when built 5 years ago$11,000,000 when built 5 years ago 55thth year depreciation (15 year with Midyear year depreciation (15 year with Midyear

Convention) is 6.93% (from tax table)Convention) is 6.93% (from tax table) $11,000,000 * (0.0693) = $762,300$11,000,000 * (0.0693) = $762,300

Food production equipment for Mountain Food production equipment for Mountain DoodoDoodo $1,500,000 installed 3 years ago$1,500,000 installed 3 years ago

Classed as 7 year property (uses 200% declining balance)Classed as 7 year property (uses 200% declining balance) 33rdrd year under Midyear convention 17.49% year under Midyear convention 17.49% $1,500,000 * (.1749) = $262,350$1,500,000 * (.1749) = $262,350

More Previously More Previously Capitalized ItemsCapitalized Items

Office Equipment $250,000 purchased 5 Office Equipment $250,000 purchased 5 years agoyears ago 5 year property (200% declining balance)5 year property (200% declining balance) 11.52% (it has switched to SL)11.52% (it has switched to SL) $250,000*(.1152) = $28,800$250,000*(.1152) = $28,800

Units of Production Units of Production DepreciationDepreciation

Most companies take tax benefits as quickly as Most companies take tax benefits as quickly as possible (more money quicker)possible (more money quicker) We’ll elect to expenseWe’ll elect to expense

Suppose we have some old expenses we put Suppose we have some old expenses we put into Units of Production Depreciationinto Units of Production Depreciation $2,500,000 dollars expended for decline in past$2,500,000 dollars expended for decline in past Development provided access to 20,000,000 tons of Development provided access to 20,000,000 tons of

reservesreserves This year we produced 200,000 tons from the This year we produced 200,000 tons from the

reservereserve $2,500,000 * (200,000/20,000,000) = $25,000$2,500,000 * (200,000/20,000,000) = $25,000

Continuing My Income Continuing My Income TaxTax

$3,393,500 subtotal after Expenses$3,393,500 subtotal after Expenses Subtract Depreciation $1,129,300Subtract Depreciation $1,129,300 Subtotal $2,264,200Subtotal $2,264,200

AmortizationAmortization

Depreciation generally occurs on Depreciation generally occurs on something tangiblesomething tangible

Amortization generally occurs on Amortization generally occurs on something intangiblesomething intangible

Partly Poopers now has to deal with Partly Poopers now has to deal with AmortizationAmortization

Things to AmortizeThings to Amortize

Developing the business plan and contracts Developing the business plan and contracts that Partly Poopers used costthat Partly Poopers used cost $500,000$500,000 Amortize over 5 years by SLAmortize over 5 years by SL This is last year take $100,000This is last year take $100,000

Bought the proprietary processes, know how Bought the proprietary processes, know how and contact network when business startedand contact network when business started $3,000,000$3,000,000 Called Section 197 intangiblesCalled Section 197 intangibles

Amortize over 15 years by SLAmortize over 15 years by SL This year take $200,000This year take $200,000

More AmortizationMore Amortization

Bought the poop to gasoline patent for Bought the poop to gasoline patent for $2,000,000 – has 10 more years$2,000,000 – has 10 more years Amortize by SL over the life of assetAmortize by SL over the life of asset Take $200,000 this yearTake $200,000 this year

Leased the land for the main plant for Leased the land for the main plant for $1,000,000 for 50 years$1,000,000 for 50 years Amortize by SL over asset lifeAmortize by SL over asset life Take $20,000 this yearTake $20,000 this year

Totaling Up AmortizationTotaling Up Amortization

Amortization total $520,000Amortization total $520,000 Continuing With My Tax CalculationContinuing With My Tax Calculation Subtotal After Expenses and Subtotal After Expenses and

Depreciation $2,264,200Depreciation $2,264,200 Minus Amortization $520,000Minus Amortization $520,000 Subtotal $1,744,200Subtotal $1,744,200

Now For DepletionNow For Depletion

For Depletion we Calculate it Two Ways For Depletion we Calculate it Two Ways and Pick the Bestand Pick the Best Cost DepletionCost Depletion Percentage DepletionPercentage Depletion

Our Cost DepletionOur Cost Depletion

We finished using up and selling Land We finished using up and selling Land this yearthis year Suppose we had $200,000 in mineral rightsSuppose we had $200,000 in mineral rights Suppose we used 1/4Suppose we used 1/4thth of reserves this year of reserves this year 1/41/4thth of $200,000 is $50,000 of Cost of $200,000 is $50,000 of Cost

DepletionDepletion

Percentage DepletionPercentage Depletion

Take a % of Gross SalesTake a % of Gross Sales Stone sales were $1,500,000Stone sales were $1,500,000

Ordinary stone has a 5% rateOrdinary stone has a 5% rate $1,500,000 * (0.05) = $75,000$1,500,000 * (0.05) = $75,000

Determine whether Cost or % Depletion is Determine whether Cost or % Depletion is greatergreater $50,000 Cost Depletion$50,000 Cost Depletion $75,000 % Depletion$75,000 % Depletion

Take % DepletionTake % Depletion

Just One Little ProblemJust One Little Problem

Original exploration for the deposit (before production)Original exploration for the deposit (before production) Can elect to put it into cost basis for cost depletionCan elect to put it into cost basis for cost depletion

Often avoided because can see % depletion is normally takenOften avoided because can see % depletion is normally taken Can elect to expenseCan elect to expense

If you do – it is “recaptured” from depletionIf you do – it is “recaptured” from depletion Suppose have $325,000 we deducted 5 years agoSuppose have $325,000 we deducted 5 years ago

Suppose we have had $75,000 in depletion each year for last Suppose we have had $75,000 in depletion each year for last 4 years4 years

We didn’t actually get to take it – now “recaptured” - $300,000We didn’t actually get to take it – now “recaptured” - $300,000 Means the Tax man is still out to recapture $25,000Means the Tax man is still out to recapture $25,000

Our Depletion adjusted for Recapture is $50,000Our Depletion adjusted for Recapture is $50,000 Are number of tax situations and benefits mostly from creative Are number of tax situations and benefits mostly from creative

finance that trigger recapture. finance that trigger recapture.

My Income TaxMy Income Tax

Subtotal After Expenses, Depreciation, Subtotal After Expenses, Depreciation, Amortization $1,744,200Amortization $1,744,200

Minus Depletion $75,000Minus Depletion $75,000 Add Recapture $25,000Add Recapture $25,000 Taxable Income = $1,694,200Taxable Income = $1,694,200

Actual Income Tax has Actual Income Tax has strange bracketsstrange brackets

Lets just use 36% flatLets just use 36% flat $1,694,200*0.36 = $609,912 due in $1,694,200*0.36 = $609,912 due in

income tax.income tax.

Now For Capital Gains Now For Capital Gains TaxTax

We Sold Two Capital Assets this yearWe Sold Two Capital Assets this year Equipment $1,100,000Equipment $1,100,000 Land $400,000Land $400,000

Capital Gains on Capital Gains on EquipmentEquipment

The equipmentThe equipment Original Cost was $1,500,000Original Cost was $1,500,000 We depreciated for 3 yearsWe depreciated for 3 years Our cumulative Depreciation isOur cumulative Depreciation is

$1,500,000*(0.1429+0.2449+0.1749)= $844,050$1,500,000*(0.1429+0.2449+0.1749)= $844,050 Book Value is $1,500,000-$844,050 = Book Value is $1,500,000-$844,050 =

$655,950$655,950 We Sold for $1,100,000 - $655,950 = We Sold for $1,100,000 - $655,950 =

$444,050 in Capital Gains$444,050 in Capital Gains

We Figure All Our Capital We Figure All Our Capital Gains and Losses for the Gains and Losses for the YearYear

The LandThe Land Bought $800,000Bought $800,000 Attributed $200,000 to the mineral rightsAttributed $200,000 to the mineral rights $600,000 in Land itself$600,000 in Land itself Sold for $400,000Sold for $400,000 $400,000 - $600,000 = -$200,000 (A capital $400,000 - $600,000 = -$200,000 (A capital

loss)loss)

Now Total Our Gains and Now Total Our Gains and LossesLosses

Equipment Gain $444,050Equipment Gain $444,050 Land Loss -$200,000Land Loss -$200,000 Total Gain is $244,050Total Gain is $244,050 Calculate Our Capital Gains TaxCalculate Our Capital Gains Tax

$244,050 * 0.36 = $87,858$244,050 * 0.36 = $87,858