Most business decisions are affected either directly or indirectly by taxes. Through their taxing power, federal, state, and local governments have a profound influence on the behavior of businesses and their owners. What might prove to be an outstanding business decision in the absence of taxes may prove to be very inferior with taxes (and sometimes, vice versa). In this section we introduce you to some of the fundamentals of ta-ration. A basic understanding of this material will be needed for later chapters when we consider specific financial decisions.
We begin with the corporate income tax. Then we briefly consider personal income taxes. We must be mindful that tax iaws frequently change.
Corporate lncome Taxes
The tax rate - the percentage of taxable income that must be paid in taxes - that is applied to each income bracket is referred to as a marginal rate. For example, each additional dollar of taxable income above $50,000 is taxed at the marginal rate of 25 percent until taxable income reaches $75,000. At ihat point, the new marginal rate becomes 34 percent. The average tax rate for a firm is measured by dividing taxes actually paid by taxable income. For example, a firm with $100,000 of ta-rable income pays $22,250 in taxes, and therefore has an average tax rate of $22,2501$100,000, or 22.25 percent. For small firms (i.e., firms with less than $335,000 of taxable income), the distinction between the average and marginai tax rates may prove important. However, the average and marginal rates converge at 34 percent for firms with taxable income between $335,000 and $10 million and, finally, converge again, this time to the 35 percent rate, for firms with taxable income above $18,333,333.
Atternative Minimum Tax. Companies dislike payrng taxes and will take advantage of all the deductions and credits that the law allows. Therefore, the Internal Revenue Service has devised a special tax to ensure that large firms that benefit from the tax laws pay at least a minimum amount of tax. This special ta-r is called the ahernative minimum tax (AMT). The tax-20 percent of abernativeminimumtaxableincome(AMTI) -appliesonlywhentheAMT would be greater than the firm's normally computed tax. To broaden the base of taxable income, AMTI is calculated by applying adjustments to items that had previously received some tax preference.
Quarterty Tax Payments. Corporations of any significant size are required to make quarterly tax payments. Specifically, calendar-year corporations are required lo pay 25 percent of their estimated taxes in any given year on or before April 15, lune 15, September 15, and December 15. When actual income differs from that which has been estimated, adjustments are made. A company that is on a calendar-year basis of accounting must make final settlement by March l5 of the subsequent year.
Depreciation. Depreciation is the systematic allocation of the cost of a capital asset over a period of time for financial reporting purposes, tax purposes, or both. Depreciation deductions taken on a firm's tax return are treated as expense items. Thus depreciation lowers taxable income. Everything else being equal, the greaier the depreciation charges, the lower the ta-x. There are a number of alternative procedures for depreciating capital assets, including straight-line depreciation and various accelerated depreciation methods. The depreciation methods chosen may differ for tax reporting versus financial reporting. Most firms with ta-xable income prefer to use an accelerated depreciation method for tax reporting purposes - one that allows for a more rapid write-off and, hence, a lower taxable income figure.
The Tax Reform Act of 1986 allows companies to use a particular type of accelerated depreciation for tax purposes; it is known as the Modified Accelerated Cost Recovery System (MACRS, pronounced "makers").4 Under MACRS, machinery, equipment, and real estate are assigned to one of eight classes for purposes of determining a prescribed life, called a cosl recovery period, and a depreciation method. The property class in which an asset falls determines its cost recovery period or prescribed life for tax purposes - a life that may differ from the asset's useful or economic life. A general description of the property classes is provided. (The reader should refer to the Internal Revenue code for more detail.)