Homework Assignment Number 3 Due Date November 6 891223

Page 2 Of 2homework Assignment Number 3due Date November 6 2017ordin

Homework Assignment Number 3 Due Date: November 6, 2017 Ordinary Tax – 39.6% Capital Gain – 20% Recap on Depreciation – 25% Problem 1 XYZ LLC is planning to purchase land and a commercial building for $200,000,000. An appraisal of the property has identified that 15% of the purchase price relates to land with the remaining relating to the building. A Cost Segregation Study (“Cost Seg”) was performed which showed that 90% of the building cost related to real property and that 8% and 2% related to 7 and 5 year personal property respectively. XYZ LLC plans to hold the property for 7 years and then sell it for $210,000,000. Calculate the after tax IRR assuming no cash flow other then tax savings from depreciation under two alternatives: 1) assuming no Cost Seg data is used to calculated depreciation and 2) Cost Seg data is used.

Also, assume that when the personal property is sold that it will have no value. Economic Gain – 10 million Depreciation rates are as follows: · Real Property – 39 year straight line · 7 and 5 Year Personal Property – double declining with switch to straight line or: 7 Year Property 5 Year Property 1. 14.29% 1. 20% 2. 24.49% 2. 32% 3. 17.49 % 3. 19.2% 4. 12.49 % 4. 11.52% 5. 8.93 % 5. 11.5% 6. 8.92 % 6. 5.76% 7. 8.. 4.46 Problem 2 Agatha is planning to start a new business venture and must decide whether to operate as a sole proprietorship or incorporate. She projects that the business will generate annual cash flow and taxable income of $100,000. Agatha’s personal marginal tax rate, given her other sources of income, is 35 percent. Problem 2 (continued) a. If Agatha operates the business as a sole proprietorship, calculate the annual after-tax cash flow available for reinvestment in the business venture. b. If Agatha operates the business as a regular (C) corporation that makes no dividend distributions, calculate the annual after-tax cash flow available for reinvestment in the business. c. Now suppose that Agatha wishes to withdraw $20,000 per year from the business, and will reinvest any remaining after-tax earnings. What are the tax consequences to Agatha and the business of such a withdrawal if the business is operated as a sole proprietorship? How much after-tax cash flow will remain for reinvestment in the business? How much after-tax cash flow will Agatha have from the withdrawal? d. What are the tax consequences to Agatha and the business of a $20,000 withdrawal in the form of a dividend if the business is operated as a C corporation? How much after-tax cash flow will remain for reinvestment in the business? How much after-tax cash flow will Agatha retain from the dividend? e. If Agatha wishes to operate the business as a corporation but also wishes to receive cash flow from the business each year, what would you recommend to get a better tax result?

Paper For Above instruction

Introduction

In the realm of business finance, understanding the implications of different organizational structures and asset depreciation strategies is essential for maximizing after-tax returns and optimizing cash flows. This paper analyzes two complex scenarios: the first involves an investment property with depreciation considerations, while the second compares sole proprietorship and corporate structures for a new business venture. Each scenario highlights critical tax implications, cash flow consequences, and strategic decisions that influence overall profitability and reinvestment potential.

Scenario 1: Real Estate Investment and Depreciation Strategies

XYZ LLC's planned purchase of land and a commercial building exemplifies the importance of precise depreciation calculations and tax planning. The property's purchase price of $200 million is divided into land (15%) and building (85%), with subsequent cost segregation revealing that only 90% of the building's value is attributable to real property, and the remaining 10% to personal property with shorter depreciation periods.

Without utilizing Cost Segregation Data

If the default straight-line depreciation method is employed based solely on the building's overall value, the depreciation expense is calculated over 39 years for the real property and is uniformly distributed. The annual depreciation expense would be the building's cost ($170 million) divided by 39, approximating $4.36 million annually, leading to a total tax shield that enhances after-tax cash flows. Over seven years, cumulative depreciation reduces taxable income, resulting in tax savings that influence the IRR.

When Cost Segregation Data is used

Applying detailed depreciation schedules to personal property accelerates depreciation, increasing early-year tax savings. The 7-year and 5-year property components depreciate at accelerated rates (e.g., 20% and 32% respectively annually), significantly boosting early cash flows and potentially enhancing IRR. At the sale after seven years, the residual value of personal property is assumed to be zero, simplifying tax calculations. The differential treatment of depreciation impacts the investment's after-tax IRR significantly.

Tax Rate and Capital Gains

Depreciation recaptures and capital gains taxes are applied upon sale, with standard tax rates of 39.6% and 20% respectively. The economic gain of $10 million is subject to capital gains unless recaptured depreciation is higher. The comprehensive calculation involves projected sale price, accumulated depreciation, and tax liabilities, which influence the net after-tax proceeds and IRR.

Scenario 2: Business Structure Decision

Agatha's decision between a sole proprietorship and a C corporation hinges on after-tax cash flows, tax liabilities, and flexibility. As a sole proprietor, she faces personal marginal tax rates applied directly to business income, resulting in specific after-tax cash flows available for reinvestment. Incorporation introduces corporate tax rates and potential double taxation on dividends, impacting overall profitability and cash flow.

Part (a): Sole Proprietorship

In a sole proprietorship, the business income ($100,000) is taxed at Agatha's marginal rate (35%), leading to an after-tax profit of $65,000. This amount, combined with the cash flow, reflects the reinvestment capacity after personal taxes.

Part (b): C Corporation

As a C corporation, the business pays corporate taxes (~21% typical rate), and any undistributed profits are taxed at the corporate level. The residual cash flow, after taxes, is higher initially due to the corporate tax shield, but dividend distributions to Agatha will be taxed again at her marginal rate, resulting in potential double taxation.

Part (c): Cash Withdrawal as Reinvestment

If Agatha withdraws $20,000 annually, the tax implications differ between structures. In a sole proprietorship, such withdrawals are not taxed separately but reduce the taxable income, whereas in a corporation, the withdrawal could be classified as a dividend or salary, each with distinct tax consequences. The remaining cash flow for reinvestment will depend on these classifications and taxation.

Part (d): Dividend Distributions

Distributing dividends as a method of withdrawal subjects the corporate profits to double taxation: corporate level and personal level, at 39.6% and 20%, respectively. The net after-tax cash flows indicate the retained earnings for reinvestment and the amount that Agatha retains personally.

Part (e): Recommendations for Optimal Tax Strategy

To maximize after-tax cash flows, operating as a corporation with strategic dividend and salary planning can reduce overall tax liabilities. Balancing distributions and reinvestments, considering the tax implications, will optimize cash flow and profitability.

Conclusion

Strategic tax planning and organizational structuring are vital for maximizing after-tax returns and cash flow management. The choice between asset depreciation strategies and business structures significantly affects long-term profitability. Using accelerated depreciation via Cost Segregation can enhance early cash flows, while choosing the appropriate business form influences tax liabilities and reinvestment capacity. Careful analysis and strategic planning can lead to optimized financial outcomes for investors and entrepreneurs alike.

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