Calculating Taxable Income
Written by: Christopher J. Farrugia
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Email This TutorialIn this tutorial, we will show you how to calculate a firm's taxable income. This is really an accounting exercise more than anything, but it is worth posting on the site since I understand how much we all love financial accounting! You will need to be familiar with income statements to handle these problems, so we'll walk you right through that process.
Income Statements can come in a variety of forms, but one thing they will all have in common is that revenue (or sales) will be on top and net income will be on the bottom. When a problem asks you to find taxable income, you're really just looking for earnings before taxes or EBT. Let's jump right into a problem to show how this all comes together.
Sample Problem 1
Bird Seed Corporation had sales last year of $1,000,000. Their cost of goods sold amounted to 40% of sales and operating expenses amounted to 15% of sales. The firm also has packaging equipment with annual depreciation of $80,000. Bird Seed Corporation has an outstanding loan of $2,000,000 with an interest rate of 9%. Calculate the firm's taxable income.
Solution
The problem gives us a bunch of numbers, so let's put them into an income statement. We know sales will go up top, and then we just start subtracting out the costs. Your finished income statement should look like this:
Bird Seed Corporation Income Statement |
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 |
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Sales |
$1,000,000 |
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Cost of Goods Sold |
(400,000) |
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Operating Expenses |
(150,000) |
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Depreciation |
(80,000) |
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EBIT |
370,000 |
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Interest Expense |
(180,000) |
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Taxable Income |
$190,000 |
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What you should notice is that we just started with sales and subtracted out our costs, including depreciation. You're always going to take depreciation out in this step, since depreciation helps us lower our tax bill. Also notice that we have a line in our income statement called Interest Expense. This is simply the interest that we pay each year on any debt. In this problem, Bird Seed Corporation had a loan from the local bank. The amount of interest they pay each year is simply 9% times $2,000,000. So once we're all done, we have the answer to our problem! The taxable income is $190,000! That problem was pretty straight forward. Let's try another.
Sample Problem 2
Black & Blue Collection Agency had revenue last year of $500,000. Their cost of goods sold was $100,000 and operating expenses consisted of salaries of $80,000, labor of $60,000, and maintenance on their phone system of $5,000. The phone system was has annual depreciation of $25,000. The firm has a $250,000 loan with National Bank at 8% interest. Finally, the firm paid dividends to its shareholders of $100,000 and received dividends from their investments totaling $30,000. Calculate the firm's taxable income.
Solution
So this problem does two things differently. First, it breaks the operating expenses up to their individual items. That's no big deal! We'll just separate them on our income statement. But what is that stuff about dividend income and dividends paid?
There's a simple rule here to remember on dividends. We will completely ignore the dividends we pay out! These do not show up on our income statement when we're finding taxable income. However, dividends we receive have to show up! If we're getting dividend income from our investments, the government will definitely want their fair share. Currently, 70% of dividend income is excluded from taxes. In other words, we will have to include 30% of dividend income on our income statement. Always add this amount in as a positive number because it raises our taxable income.
Black & Blue Income Statement |
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Sales |
$500,000 |
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Cost of Goods Sold |
(100,000) |
|
Operating Expenses |
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Salaries |
(80,000) |
|
Labor |
(60,000) |
|
Maintenance |
(5,000) |
|
Depreciation |
(25,000) |
|
EBIT |
230,000 |
|
Dividend Income |
9,000 |
|
Interest Expense |
(20,000) |
|
Taxable Income |
$219,000 |
|
As you can see in this one, we ignored the dividends that the company paid. Then, we know they received $30,000 in dividend income. But, we're only responsible for 30% of that, so 30% times $30,000 gave us the $9,000 that we included on our income statement.
Feeling good about taxable income? Give these two problems a shot on your own!
Practice Problem 1
Clemens Rocket Corporation had sales last year of $5,000,000. Cost of goods sold amounted to 50% of sales and cash operating expenses amounted to 12% of sales. Depreciation was $100,000 for the year. The firm paid dividends of $250,000 and received dividend income of $150,000. The firm also had an interest expense of $400,000. Calculate Clemens' taxable income.
Solution
If all went well, you should have arrived at a taxable income of $1,445,000. If this isn't the answer you calculated, make sure you've added only 30% of the dividend income. Remember that you will ignore the dividends the company paid. If you're stumped, get some help in our forums.
Practice Problem 2
Red Roses Incorporated had sales of $2,000,000 last year with cost of goods sold of $1,200,000. Operating expenses amounted to 10% of sales. The firm also recorded $50,000 in depreciation expense for the year. The firm has $1,000,000 in outstanding bonds with an 8% coupon rate. Finally, the firm paid $65,000 in dividends for the year. Calculate Red Roses Incorporated's taxable income.
Solution
Did you get $470,000 for your taxable income? If not, check to make sure you didn't include any dividend income. They paid dividends but remember that we don't include those in our income statement.
That's a long tutorial but we hope it helped! If you have any questions or need help with your homework, please check out the Understand Finance forums!