4186 Part Three The Measurement of rable Sources of Book/Tax Differences Questions and Problems for Discussion Permanent Temporary «+ Percentage depletion in excess of cost + Intangible drilling costs (IDC) depletion + Inventory costs capitalized under UNICAP MACRS depreciation Section 179 deduction ‘Bonus depreciation ‘Amortization of organizational and start-up costs Amortization of purchased intangibles (goodwill) Goodwill impairment expense adjusted basis 162 intangible drilling and organizational costs 179 amortization 179 development costs passenger automobiles 174 onus depreciation 177 (DC) 161 percentage depletion 184 capitalization 158 leasehold costs 187 recovery period 168 cost basis 163 leasehold research and experimental cost depletion 183 improvements 181 expenditures 167 cost of goods sold 165 leverage 164 Section 179 election 175 depreciation 167 LIFO. 167 specific identification expansion costs 180 midmonth convention 170 method 166 FIFO 167 ‘midquarter convention 169 start-up expenditures 180 going-concem value 181 Modified Accelerated tax basis 162 goodwill 187 ‘Cost Recovery System uniform capitalization half-year convention 169 (MACRS) 167 (unicap) rules 166 1. How is the principle of conservatism reflected in the tax law's premise concerning the deductibility of business expenditures? +2, Assume that Congress enacted legislation requiring firms to capitalize advertising ‘costs and amortize them over 20 years. Discuss the potential effects of such legislation ‘on the amount of advertising that firms purchase and the price that advertising compa: nies charge for their product. Discuss the relationship between cost recovery deductions and cash flows. “To what extent do cost recovery deductions based on the capitalized cost of a tangible asset reflect a decline in the economic value of that asset? (Can a firm have a negative tax basis in an asset? Ifthe tax law did not allow farming businesses to deduct soil and water conservation texpenditures but required capitalization of these costs, in what year or years would farmers recover these costs? Corporation J manufactures electrical appliances. Corporation K. provides arcitee tural services. During the year, both corporations paid $56,000 annual premiums «9 teamy fire and casualty insufance on their tangible assets. Corporation J was required to capitalize the $56,000 cost for tax purposes while Corporation K was allowed & '$56,000 deduction, Can you explain this difference in tax treatment between the (Wo corporations?Application Problems Identify the tax and nontax issues that firms must consider in adopting the LIFO method of accounting for inventories. Identify four possible differences in the computation of depreciation expense for fina: cial statement purposes and MACRS depreciation, What is the purpose of the MACRS half-year, midquarter, and midmonth conventions? Why do the MACRS tables published by the IRS incorporate 2 depreciation convention for the first year during an asset's recovery period but not for the year of disposition? Discuss the reasons why the Section 179 election is more valuable to small firms than to large firms. Firm O purchased two items of business personalty this year. The first item cost $35,000 and has a five-year recovery period, and the second item cost $61,500 and has a seven-year recovery period. Firm O wants to make the Section 179 election for one of its new assets. Which asset should the firm choose and why Discuss the strengths and weaknesses of the tax rule providing for 15-year amortiza- tion of the cost of business acquisition intangibles. Describe the difference in tax treatment between start-up costs of a new business and expansion costs of an existing business. On February 1, Mr. B purchased a business from Mr. and Mrs. § for a lump-sum price of $750,000, The business included the following balance sheet asses, Appraised FMV Accounts receivable $27,600 Inventory 195,000, ‘Office supplies (4 months worth) 8,500 Furniture and fixtures 395,000, By buying the business, Mr. B acquired a favorable lease on office space with remaining term of 31 months; he estimates that the value of this lease is $20,000. The purchase contract stipulates that Mr, and Mrs. S will not engage in a competitive busi- ness for the next 36 months. Discuss how Mr. B can recover the cost of each of the ‘business assets acquired in this purchase, Firm W and Firm X both have goodwill and going-concem value worth approximately $1 million. However, only Firm X reports an amortization deduction with respect to its goodwill and going-concemn value on its tax retum. Can you explain this difference in tax treatment between the two firms? ‘Under what circumstances is percentage depletion not a true cost recovery deduction? ‘Assuming a 25 percent tax rate, compute the after-tax cost of the following business expenditures. $14,200 cost of a survey capitalized to land. $44,750 research and experimental expenditure. $23,000 advertising cost. {$120,000 cost of grading land used in a nonfarming business. {$120,000 cost of grading land used in a farming business.488 Part Three ‘The Measurement of Taxable Income Determine the tax basis of the business asset acquired in each of the following cases. a. Firm L paid $5,950 cash plus $416 sales tax plus a $500 installation charge for a satelite dish, b, TTP Inc. acquired inventory in exchange for 800 shares of TTP common stock listed on Nasdaq at $212 per share on the date of exchange. Firm Q acquired machinery in exchange for architectural drawings rendered by Firm's Q's junior partner. The partner spent 20 hours on the drawings, and his hourly billing rate is $350. ‘d. Company C purchased equipment by paying $2,000 cash at date of purchase and financing the $18,000 balance of the price under a three-year deferred payment plan. Early this year, ZeZe Inc. paid a $52,000 legal fee in connection with a dispute over ZeZe’s title to investment land. ZeZe’s apditors required the corporation to expense payment on this year’s financial statements, According to ZeZe's tax adviser, the payment is a nondeductible capital expenditure. ZeZe's tax rate is 35 percent. 4. Compute the deferred tax asset ora deferred tax liability (identify which) resulting from this difference in accounting treatment. b When will the temporary difference reverse? In 2013, Firm A paid $50,000 cash to purchase a tangible business asset, In 2013 and 2014, it deducted $3,140 and $7,200 depreciation with respect to the asset. Firm A's ‘marginal tax rate in both years was 35 percent. a. Compute Firm A's net cash flow attributable to the asset purchase in each year i. Compute Firm A’s adjusted basis in the asset at the end of each year Refer to the facts in problem 4, Now assume that Firm A borrowed $50,000 to pur- chase the asset. In each year, it paid $3,800 annual interest on the debt. The interest payments were deductible. ‘a. How does this change in facts affect Firm A’s net cash flow attributable tothe asset purchase in each year’ +b. How does this change in facts affect Firm A's adjusted basis in the asset at the end of each year? In year 0, Jarmex paid $55,000 for an overhaul of «tangible operating asset. Jarmex hhas a 34 percent marginal tax rate and yses a 7 percent discount rate o compute NPV. ‘a. Compute the after-tax cost of the overhaul if Jarmex can deduct the $55,000 pay ment as a repair in year 0. +b Compute the after-tax cost ofthe overhaul if Jarmex must capitalize the $55,000 pay- ‘ment to the asset account and can recover it on a straight-line basis in years 0, 1,2, and 3. Company XYZ manufactures a tangible product and sells the product at wholesale. In ts fist year of operations, XYZ manufactured 1,000 units of product and incurred {$200,000 direct material cost and $130,000 direct labor costs. For financial statement purposes, XYZ, capitalized $85,000 indirect costs to inventory, or tax purposes it had to capitalize $116,000 indirect costs to inventory under the unicap rules, At the end of its fist year, XYZ held 260 units in inventory. Compute XYZ's cost of goods sold for book purposes and for tax purposes. Refer to the facts in problem 7. In its second year of operations, XYZ manufactured 2,000 units of product and incurred $41 0,000 direct material cost and $275,000 di rect labor costs. For financial statement purposes, XYZ. capitalized $139,000 indirect costs to inventory. For tax purposes, it had to capitalize $193,000 indirect costs £0 jnventory under the unicap rules. At the end of its second year, XYZ held 300 items in.Chapter 7 Property Acquistions and Gost Reco inventory. Compute XYZ's cost of goods sold for book purposes and for tax purposes assuming that: a. XYZ uses the FIFO costing convention, b, XYZ uses the LIFO costing convention. Firm J purchased a depreciable business asset for $62,500. Assuming the firm uses the half-year convention, compute its first-year MACRS depreciation ifthe asset is: 4. A land irrigation system. +b, Duplicating equipment ¢. An oceangoing barge. dd. Small manufacturing tools Herelt Inc., a calendar year taxpayer, purchased equipment for $383,600 and placed it in service on April 1, 2014. The equipment was seven-year recovery property, and Herelt used the half-year convention to compute MACRS depreciation, a Compute Herel’s MACRS depreciation wit respect to the equipment for 2014 and 2015. b, Compute Herelt’s adjusted basis in the equipment on December 31, 2015, ¢. Compute Herelt’s MACRS depreciation for 2016 if it disposes ofthe equipment on February 9, 2016. Knute Company purchased only one asset during its calendar taxable year. The asset cost $650,000 and has a three-year recovery period. Compute Knute's MACRS depre- ciation with respect to this asset over the recovery period assuming that 4, The asset was placed in service on August 18. +, The asset was placed in service on November 9. Erwin Company, a calendar year taxpayer, made only two purchases of depreciable per- sonalty tis year. The fist purchase was five-year recovery property costing $312,800, and the second purchase was seven-year recovery property costing $574,000. Compute Enwin’s first-year MACRS depreciation with respect tothe personalty assuming that 4. The first purchase occurred on February 2, and the second purchase occurred on June 18, », The first purchase occurred on February 2, and the second purchase occurred on October 13, Suber Inc., a calendar year taxpayer, purchased equipment for $800,000 and placed it in service on March 1. Suber’s chief engineer determined that the equipment had an estimated useful life of 120 months and a $50,000 residual value. For financial state- ment purposes, Suber uses the straight-line method to compute depreciation, 4. Compute book depreciation for the year ‘4, Assuming that the equipment has a seven-year recovery period and is subject to the half-year convention, compute MACRS depreciation for the year: ‘e. Compute Suber’s book basis and tax basis in the equipment atthe beginning of next year Ryland Company, a calendar year taxpayer, purchased commercial realty for $2 mil lion and allocated $200,000 cost to the land and $1.8 million cost to the building Ryland placed the real estate in service on May 21 44, Compute Ryland’s MACRS depreciation with respect to the realty for the year of purchase, How would your answer change if Ryland placed the realty inservice on September 2 instead of May 217 How would your answer to part a change if the building was a residential apartment complex instead of a commercial office?490 Part Three The Measurement of Taxable Income 15, AP constructed a new manufacturing plat for a total cost of $9,465,000 and placed it in service on March 2. To finance the construction, AP took out a $6 million, 30-year ‘mortgage on the property. Compute AP's MACRS depreciation for the manufacturing plant forthe first, second, and third years of operation. . On May 12, 2013, Nelson Inc. purchased eight used-passenger automobiles for use in its business. Nelson did not make a Section 179 election to expense any portion ofthe cost ofthe automobiles, which are five-year recovery property subject to the half-year convention, Compute Nelson’s depreciation deduction with respect to the automobiles for 2013 and 2014 assuming: 4, The automobiles were Mini Coopers costing $14,300 each. , The automobiles were Buick Lucemes costing $27,000 each, |. Margo, a calendar year taxpayer, paid $80,000 for machinery (seven-year recovery property) placed inservice on August 1, 2014, 4a. Assuming that the machinery was the only tangible property placed in service dur- ing the year, compute Margo's maximum cost recovery deduction. », How would your computation change if Margo paid $210,000 for the machinery? ¢ How would your computation change if Margo paid $300,000 forthe machinery? 4. How would your answer to part a. change ifthe machinery was placed inservice in2013? 3. In 2014, Firm L purchased machinery costing $21,300 and elected to expense the ‘entire cost under Section 179. How much ofthe expense can Firm L deduct in each of the following cases? 4. Its taxable income before the deduction was $58,000. 2, Is taxable income before the deduction was $19,200. 6, Its net operating loss (NOL) before the deduction was $5,016. In 2013, Company W elected under Section 179 to expense $69,300 of the cost of qualifying property. However, it could deduct only $65,000 ofthe expense because of the taxable income limitation. In2014, Company W's taxable income before any Sec- tion 179 deduction was $812,000, Compateits 2014 Section 179 deduction if 4. The total cost of qualifying property purchased in 2014 was $13,600. 2, The total cost of qualifying property purchased in 2014 was $25,000. Loni Company paid $527,000 for tangible personaly in 2012 and elected to expense $500,000 of the cost (the limited dollar amount for 2012). Loni’s taxable income be- fore a Section 179 deduction was $394,100. Loni paid $63,700 for tangible personalty in 2013 and elected to expense the entire cost. Loni’ taxable income before a See- tion 179 deduction was $228,000. 4. Compute Loni Section 179 deduction and taxable income for 2012. 2. Compute Loni’s Section 179 deduction and taxable income for 2013. . At the beginning ofits 2014 tx year, Hiram owned the following business assets. Date Placed initial Accumulated Recovery Depreciation ‘inService Cost__Depreciation Period _ Convention. Furniture 6/19/12 $30,750 $11,925 Tear Half-year Equipment 5/2/11. 70,000 49,840 Syear —_Half-year Machinery 980/11 58,000 41,296 S-year ——Half-year (On July 8, Hiram sold its equipment. On August 18, it purchased and placed in ser- vice new tools costing $89,000; these tools are three-year recovery property. TheseChapter 7 Property Acauisitions and Cost Recovery Ded ‘were Hiram’s only capital transactions for the year, Compute Hiram’s cost recovery deduction for 2014. In making your computation, assume that taxable income before depreciation exceeds $500,000. In April 2013, Lenape Corporation acquired new business machinery with a total cost ‘of $775,000. Assuming the machinery qualifies for both the Section 179 deduction and bonus depreciation, calculate Lenape’s total cost recovery on the machinery for 2013, ‘Ajax Inc. was formed on April 25 and elected a calendar year for tax purposes. Ajax paid $11,200 to the attorney who drew up the articles of incorporation and $5,100 to the CPA who advised the corporation concerning the accounting and tax implications ofits organization. Ajax began business operations on July 15. To what extent can Ajax deduct its $16,300 organizational costs on its first tax return? Mr. and Mrs. FB, a retired couple, decided to open a family restaurant. During March and April, they incurred the following expenses. Prepaid rent on commercial realestate ($2,100 per month from April through December) $18,900 Prepaid rent on restaurant equipment ($990 per month from April through December) ato ‘Advertsing of upcoming Grand Opening ‘900 Staff hiring and training 11,500 $40,210 Mr. and Mrs. FB served their first meal to a customer on May 1, Determine the tax ‘treatment of the above expenses on their tax return, Mr.Z, a calendar year taxpayer, opened a new car wash. Prior to the car wash’s grand. ‘opening on October 8, Mr. Z incurred various start-up expenditures (rent, utilities, ‘employee salaries, supplies, etc.). In each of the following cases, compute Mr. Z's first-year deduction with respect to these expenditures. 4a, The start-up expenditures totaled $4,750. b, The start-up expenditures totaled $27,320. ¢. The start-up expenditures totaled $53,120. . The start-up expenditures totaled $88,380. MNO is a calendar year taxpayer. On March 1, MNO signed a 36-month lease on 2,100 square feet of commercial office space. It paid a $3,240 fee to the real estate agent who located the space and negotiated the ease and $8,800 to install new overhead lighting in the office space. Lighting equipment is seven-year recovery property. Compute MNO's first-year ‘cost recovery deduction with respect to the $12,040 cost relating to the lease space. On April 23, Mrs. Y purchased a taxi business from Mr. M for a $60,000 lun price. The business consisted of a two-year-old taxicab worth $19,000, Mr. M's to operate a taxi business in Baltimore, his lst of regular customers, and his registered ‘business name “On Time Any Time Taxi.” Mrs. ¥ operated the business from April 24 through the end of the year ‘a, Compute Mrs. ¥’s taxable income from the taxi business if her taxable income before any cost recovery deductions was $36,890. Assume Mrs. Y wants to mini- mize taxable income. Compute Mrs. Y’s taxable income from the taxi business if her taxable income before any cast recovery deductions was $17,100. Assume Mrs. Y wants to mini- mize taxable income.192 Part Three ‘he Measurement of Table 28, On November 13, Underhill Inc, a calendar year taxpayer, purchased a business for ‘4 $750,000 lump-sum price. The business's balance sheet assets had the following, appraised FMV. ‘Accounts receivable $ 38,000 Inventory 177,000 Tangible personally 400,000 $615,000, ‘What is the cost basis ofthe goodwill acquired by Underhill on the purchase ofthis business? ‘Compute Underhill’s goodwill amortization deduction for the year of purchase. ‘Assuming a 35 percent tax rate, compute the deferred tax asset or deferred tax. liabitity (identify which) resulting from Underhill's amortization deduction, ‘SEP, a calendar year corporation, reported $918,000 net income before tax on its finan- cial statements prepared in accordance with GAAP. The corporation's records reveal the following information. + SEP incurred $75,000 of research costs that resulted in a new 17-year patent for the corporation. SEP expensed these costs for book purposes. SEP’s depreciation expense per books was $98,222, and its MACRS depreciation deduction was $120,000. SEP was organized two years ago. For its first taxable year, it capitalized $27,480, start-up costs and elected to amortize them over 180 months. For book purposes, it expensed the costs in the year incurred, Compute SEP’s taxable income. TGW, a calendar year corporation, reported $3,908,000 net income before tax on its financial statements prepared in accordance with GAAP. The corporation's records reveal the following information. + TGW's depreciation expense per books was $448,000, and its MACRS depreciation deduction was $377,900. “TGW capitalized $678,000 indirect expenses to manufactured inventory for book pur- poses and $802,000 indirect expenses to manufactured inventory for tax purposes. TGW’s cost of manufactured goods sold was $2,557,000 for book purposes and $2,638,000 for tax purposes. Four years ago, TGW capitalized $2,250,000 goodwill when it purchased a com- petitor’s business. This year, TGW’s auditors required the corporation to write the ‘goodwill down to $1,500,000 and record a $750,000 goodwill impairment expense. Compute TGW’s taxable income. ‘ABZ incurred $450,000 of capitalized costs to develop a uranium mine. The corpora- tion’s geologists estimated that the mine would produce 900,000 tons of ore. During the year, 215,000 tons were extracted and sold. A&Z’s gross revenues from the sales totaled $689,000, and its operating expenses for the mine were $200,000. Calculate A&Z’s depletion deduction. Jonson Corporation incurred $150,000 in capitalized acquisition costs to develop #” oil well. The corporation's geologists estimated that there were 200,000 barrels of oil in the well at the beginning of the year, Jonson produced and sold 20,000 barrels this year, earning $140,000 of gross revenue. Its operating expenses for the well totaled $25,000. Calculate Jonson's allowable depletion deduction,Chapter 7 Property Acquisitions and Cost Recovery Deductions 193 Issue Identity te tax isue or isues suggested by the following situations and state each issue Recognition te formofa question Problems 1, Corporation J paid $500,000 for six acres of land on which it pans to build a new cor- Porate headquarters. Four months afte the purchase, Corporation J paid $20,000 to a ‘demolition company to tear down an old warehouse located on the land and haul away the rubble from the demolition site. Mr. R lived in @ two-bedroom, one-bath residence unti! August when he moved to a new home and converted his old residence into residential rent property. He had no trouble finding tenants who signed a one-year lease and moved in on September 1. AS ofthis date, the market value of the old residence was $120,000. Mr. R purchased the residence six years ago for $180,000. Mrs. K owns her own consulting firm, and her husband, Mr, K, owns & printing busi- ness. This year, Mrs. K's consulting business generated $89,000 taxable income. Mr. K’s business operated at a loss. In July, Mr. K bought new office furniture for $16,000. This was the only purchase of tangible business personalty by either spouse forthe year. Mr. and Mrs. K always flea joint tax return OI Inc. purchased a 20-acre industrial complex consisting of three warehouses and to office buildings surrounded by parking lots. About 12 acres ofthe land is undevel- ‘oped. ROJ paid a lump-sum purchase price of $19.4 million Firm PY purchased industrial equipment from a Canadian vendor. The firm paid $12,800 to transport the equipment to its manufacturing plant in Florida and a $1,700 premium for insurance against casualty or theft ofthe equipment while en route WRT owns a chain of retail bookstores. It recently decided to add coffee bars in each store to sell gourmet coffee drinks and pastries tothe bookstore customers. WRT has not yet obtained the necessary licenses required under local Iw to serve food tothe public. However, ithas incured almost $30,000 in up-front expenditures on the coffee bars In 2009, Firm Z elected to expense the $8,000 cost of a machine, which it reported as the only item of equipment placed in service that year. This year, the IRS audited Firm Zs 2009 return and discovered that it had incorrectly deducted a $10,000 expenditure. According to the IRS, Firm Z. should have capitalized this expenditure as the cost of depreciable equipment with a 5-year recovery period. Company 15, calendar year corporation, bought an airplane for use in its oil and gas business in December. The manufacturer delivered the plane to the company's hangar ‘on December 19. Because of severe winter weather, 1's pilot was unable to fly the plane on company business until February 16 ofthe next year ‘TCI bought a 10-2cre tract of undeveloped land that it intends to improve and subdivide for sale to realestate customers. Tis year, TCT paid $4,300 to a local company to clean up the land by hauling away trash, cuting down dead tres, and spraying for poison ivy Firm D paid a $500,000 lump-sum price for a commercial office building, A local con- sulting company approached Firm D with a proposal. For a $15,000 fee, the company ‘would analyze the components of the building (shelving, lighting fixtures, floor cover- ings, plumbing, etc.) to determine how much of the $500,000 price is attributable to five-year or seven-year recovery property rather than to the building itself Research Elsworthy Company operses a numberof pubic golf courses in Fria, This yar, Problems Esworthy constucted six new grees of a ype deseribed a “modern greens. Modem grcens conan sophisticated drainage systems that include subsurface dsinage ties and interconnected pipes. These tiles and pipes require replacement about evry 20 years. The cost ofeach modem green was $115,000 $30,000 fr earthmoving, grading, an shaping198 part Three “The Measurement of Taxable Income ofthe land in preparation for construction and $85,000 for construction ofthe green itself ‘What isthe correct tax treatment ofthe total cost of each modem green’? (On January 1 of every year since 1993, Lanier Corporation has paid a $35,000 retainer fee to the law firm of Myer and Weeble (MW). MW specializes in structuring corpo- rate mergers and acquisitions. In return for the annual payment, MW guarantees that it ‘will represent Lanier for one year. Moreover, MW will not provide legal assistance to ‘any business that Lanier attempts to acquire during the year. MW is entitled to keep the annual retainer regardless of the actual amount of legal work performed for Lanier. On January 1, Lanier paid the annual $35,000 retainer to MW. In August, MW structured Lanier’s acquisition of Carstron Manufacturing. MW sent Lanier a bill for $100,000 of additional legal fees in connection with this acquisition. The tax law clearly requires Lanier to capitalize the $100,000 additional legal fees as partof the cost of Carstron Manufacturing. But can Lanier deduet (rather than capital ize) the $35,000 retainer paid in January? Last year, Manabe Inc, leased a computer system from ICS Company for five years. After using the system for only 10 months, Manabee realized that it was no longer adequate for its expanding business needs. As a result, Manabee negotiated with ICS to terminate the original lease and enter into a new five-year lease under which ICS ‘would provide Manabee with an expanded, upgraded computer system. ICS would not agree to the arrangement unless Manabee paid a $200,000 lease cancellation fee. Can “Manabee deduct this fee as a current expense, or must Manabee capitalize the fee as a leasehold cost and amortize it over the five-year term of the new lease? Peter Nelson is employed full time as an accountant by an insurance company. In his spare time, he operates a secondary business as a self-employed wedding pho- tographer. On January 3, 2014, Peter purchased new video recording equipment for $22,600. During 2014, he used this equipment for personal enjoyment (filming his family members on holidays and during vacations). He also used the equipment for business purposes when a client wanted video coverage of a wedding, Peter did not purchase any other property for business use during the year Peter kept careful writen record of the time that he used the video recording equip- rent for either personal or business reasons during 2014. This record substantiates that he used the equipment 59 percent of the time for personal reasons and 41 percent of the time for business reasons. Can Peter elect to expense any of the cost ofthe video recording equipment under Section 179? Tax Planning 1. MRT,acalendar year corporation, placed the following assets in service this yea Cases eee aT Date Recovery Placed Asset Initial Cost Period __in Service Manufacturing equipment $259,000 7years —April23, Furniture and fixtures $6,000 7years = May2 Transportation ‘equipment 225,000 Syears-——September 3 Office equipment 420,000 7years_——_ December 1 4, Compute MRT’s MACRS depreciation with respect to the assets placed in service this ‘year. Assume MRT does not elect to use first-year bonus depreciation or Section 179.jctions 195 chapter? Property Acquisitions and Gast Recovery Des b. In December, MRT decided to purchase $285,000 of additional equipment. The corporation could buy the equipment and place it inservice before year-end, or it ‘could postpone the purchase until January. What effect does this decision have on MRI's depreciation with respect to the assets already in service? ial tax rate and uses an 8 percent discount rate to ‘Company C has a 34 percent margin: compute NPV, The company must decide whether to lease or purchase equipment to tice for years 0 through 7. It could lease the equipment for $21,000 annual rent, or it ‘could purchase the equipment for $100,000, The seller would require no money down ‘and would allow Company C to defer payment until year 4 at 11.5 percent simple in terest ($11,500 interest payable in years 1, 2,3, and 4). The equipment would be seven- ‘year MACRS recovery property with no residual value. Should Company C lease or purchase the equipment to minimize the aftertax cost ofthe use of the property for eight years? MG, a corporation inthe 34 percent marginal tax bracket, owns equipment thats fully depreciated. This old equipment is stl operating and should continue to do so for four years (years , 1,2, and 3). MG's chief financial officer estimates tha repair costs forthe old equipment will be $1,400 in year 0, $1,400 in year 1, $1,500 in year 2, and $1,600 in year 3. At the end of year 3, the equipment will have no residual value ‘MG could junk the old equipment and bay new equipment for $5,000 cash. Th equipment will have a three-year MACRS recovery period, should not require any irs during years 0 through 3, and will have no residual value at the end of year 3 ‘a. Assume MG cannot make a Section 179 election to expense the $5,000 cost of the new equipment. Which option (keep old or buy new) minimizes MG's after-tax cost? In making your calculations, use a 10 percent discount rate. bs. Assume MG can make a Section 179 election to expense the entire $5,000 cost of, the new equipment, Under this change in facts, which option (keep old or buy new) ‘minimizes MG's after-tax cost? KP Inc, is negotiating a 10-year lease for three floors of space in a commercial office building, KP can't use the space unless a security system is installed. The cost of the system is $50,000, and it will qualify as seven-year recovery property unkler MACRS. The building's owner has offered KP a choice. The owner will pay for the installation of the security system and charge $79,000 annual rent, Alternatively, KP can pay for the installation ofthe security system, and the owner will charge only $72,000 annual rent, Assuming that KP has a 35 percent marginal tax rate, cannot make a Section 179) flection to expense the $50,000 cost, and uses a 9 percent discount rate to compute NPY, which alternative should it choose? Mr S paid $16,600 cash for tangible asset fr use in his new business. The asset is three year recovery property. Before consideration of any cost recovery: deduction, the business fever, Mr. and Mrs. § have other sources of zenerated a net loss this year (year 0). How: income, so they ean deduct the entire business loss on their individual tax return. MES has two choices with respect to the new asset. He can capitalize the cost and depreciate it under MACRS. Altematively, he can elect to expense the cost under ‘Section 179, Because his business generates no taxable income, the expense would be nondeductible, However, it would carry forward into future years. Mr. S predicts thatthe business will operate ata loss for next year (year 1) but should generat atleast $20,000 income the following year (year 2). Consequently, he ean deduct the Section 179 ex pense carryforward in that year. If Mr. and Mrs. S's marginal tx rate is 25 percent and they use a 7 percent discount rate to compute NPV, should Mr. § elect toe cost of the new business asset?196 Part Three The Measwrement of Taxable Income Midquarter Convention Le for Br juarter Convent css Personalty Placed In Service in First Quarter Depreciation Rate for Recovery Period oor B¥ear—=SNear—7-¥ear_—TWear_—15-Year_—_20-¥ear 7 $ea3% 35.00% 25.00% 17.50% 875% 6.563% ) SRY 60" dias” testa 00 ee cy a Tse tor tba 1088738 8.86 5 11.01 8.75 845 6.65 5.546 —_ é 13 are 6785895130 7 Br 655 590 aa é yo -655 Sat 4.9 ° ese 58089 10 63551 “as n oe 55058 2 soi 4.60 3 so ase “ S140 1S 5.90 4.459 Sees” 3000371750838 gi 5 tete = tee 676 = 400 baw 612 a S30 tig)? 1120 7588816 5 1137 887 896 683 ses il é fae fer) GIs Sa > ber 655 Sota 3 Ss 30s 5 bse 51 aes © bss sao so n oas $0146 2 sso 4a 3 591 = ‘ $20 15 5.91 oe "6 271 0 i8 °Chapter? Proper nd Cost Recovery Dect Midquarter Convention for Business Personalty Placed in Service in Third Quarter Depreciation Rate for Recovery Period BYear —SYear — 7-Year —‘10-Year_—‘15-Year__—_20-Vear 25.00% 15.00% 10.71% 750% 375% 2.813% 50.00 34002551 18.50 968 16.67 20.40 18.22 14.80 8.66 833 12.24 13.02 1.84 7.80 1130 9.30 9.47 7.02 7.05 885 758 631 aa 655 5.90 655 5.90 656 591 655 5.90 410 531 5.90 5391 590 591 3.69 Mildquarter Convention for Business Personalty Placed in Service in Fourth Quarter Depreciation Rate for Recovery Period 3Year 5-Year_——7-Year_—10-Year_—«15-Year_—_—_—20-Year 833% 5.00% «357% 250% 125% 0.938% ei! 38.00 2755 1950 oe 7.430 2037 22.80 19.68 1560 a9 10.19 13.68 14.06 12.48 8.00 10.94 0.08 9.98 720, 958 873 799 648 a3 655 5.90 7.64 655 530 6.56 5.90 655 591 5.74 5.90 531 531 5.90 5.17