Yesterday, we talked about tax deductions, tax credits, marginal tax rates, and effective tax rates. Today, we’re going to continue the discussion with a look at before- and after-tax returns.
You have to be very careful about combining before-tax and after-tax returns in your financial summary. People combine these two concepts all the time – probably unwittingly. Unfortunately, doing so can tarnish an otherwise accurate financial summary. I touched on this topic briefly in the “Calculating Costs” blog last week, and it warrants some further explanation.
Let’s assume you have a situation where a project is going to save your prospect $1,000 a year in utility bills and provide a depreciation deduction of $250. It’s not fair to say, “You’re going to get $1,000 PLUS a tax savings equal to your marginal tax rate times $250.” Why not? Because, assuming your prospect’s business deducts utilities on their tax return, they’re not saving $1,000 on an after-tax basis. They’re actually saving the after-tax value of that $1,000 expense. In other words, in the absence of your project, your prospect would continue to spend $1,000 on utilities, and assuming a 35% marginal tax bracket, they would be saving $350 in federal income tax as a result, which would mean that their after-tax utility expense would be $650.
If you were to take the before-tax savings of $1,000 and add the value of the depreciation tax shield (i.e., the $250 depreciation deduction times the marginal tax rate), you would be mixing before-tax and after-tax effects.
While we’re on the topic, whenever you’re deciding how to work this information into your financial summary, make sure that you don’t assume your prospect has a “tax appetite,” even if the organization is a taxable entity. What if they had a lackluster year and no taxable income? What if they had a bad year last year and have a net operating loss to carry forward? What if they purchased a lot of equipment this year and have a bundle of investment tax credits to use? In any of these scenarios (and many others), there may be little or no taxes owed, in which case there may be little or no incentive to secure additional tax deductions or credits.
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