UNIT-5

TAXES AND INSURANCE

INTRODUCTION:

Expenses for taxes and insurance play an

important part in determining the economic
situation for any industrial process.
Because Federal, state, and local taxes may
amount to a major portion of a concern’s
earnings.
Insurance costs ordinarily are only a small part
of the total expenditure involved in an
industrial operation; however, adequate
insurance coverage is necessary before any
operation can be carried out on a sound
economic basis.
Taxes are levied to supply funds to meet the
public needs of a government.

Insurance is required for protection against

certain types of emergencies or catastrophic
occurrences.

Insurance rates and tax rates can vary

considerably for business concerns as
compared to the rates for individual persons.
TYPES OF TAXES:
Taxes may be classified into three types.

 Property taxes,
 Excise taxes, and
 Income taxes.

These taxes may be levied by the Federal government,

state governments, or local governments
Property Taxes:

Local governments usually have jurisdiction

over property taxes, which are commonly
charged on a county basis.

Individual cities and towns may have special

property taxes for industrial concerns located
within the city limits.
Property taxes vary widely from one locality to
another.

The average annual amount of these charges is

1 to 4 percent of the assessed valuation.

It is a direct since they must be paid directly

by the particular concern and cannot be passed
on as such to the consumer
Excise Taxes

 Excise taxes are levied by Federal and state

governments.

 Federal excise taxes are

1) Charges for import customs duties
2) Transfer of stocks and bonds, and a large
number of other similar items.
Manufacturers and retailers excise taxes are
levied by Federal and state governments on the
sale of many products such as gasoline and
alcoholic beverages.
These taxes are indirect since they can be
passed on to the consumer.
Many business concerns must also pay excise
taxes for the privilege of carrying on a
business in their particular localities.
Income Taxes:

Income taxes are based on gross earnings.

Gross earnings =Total income - Total product cost.

Revenue from income taxes is an important

source of capital for both Federal and state
governments.
National and State laws change from year to
year.

State income taxes vary from one state to

another.

State income taxes may range from 0 to 5

percent or more of gross earnings
FEDERAL INCOME TAXES:

The Federal government has set up an

extremely complex system for determining
income taxes for business establishments.
 New laws are added and old laws are changed
each year.
Final determination of income-tax payments
should be made with the aid of legal and
accounting tax experts.
Normal Tax:
Normal tax has been levied by the Federal
government on the earnings of corporations.
The tax rate is set by the national lawmakers..

Surtax:
In addition to the normal tax, corporations have
had to pay a second Federal income tax on
gross earnings above a certain base limit. This
additional tax is known as a surtax.
• Capital-Gains Tax:

A capital-gains tax is levied on profits made

from the sale of capital assets, such as land,
buildings, or equipment.

The profit is known as long-term capital gain if

the asset was held for more than one year and
short-term capital gain if the asset was held for
less than one year.
 The net capital gain = short-term + long-term capital gains

The tax is paid on net capital gain at the same

rate as ordinary income in the year the gain
occurred.

The tax rate for corporations capital gains

would be 34 percent.
Tax Exemption for Dividends Received:

Corporations are given a partial tax exemption

for dividends received.

In general, only 15 percent of such dividends

are considered as taxable income for
corporations, with the remaining 85 percent
being tax exempt.
Contributions:
Corporate contributions to appropriate
organizations can be deducted as an expense
up to 10 percent of the taxable income .

Ex: A corporation which is paying income tax at

a 34 percent rate, a contribution of $10,000
would represent an actual cost to the
corporation after taxes of only $6600.
Carry-back and Carry-forward of Losses:

The analyses of taxes have been based on the

assumption that the corporations involved
were operating at a profit.

If the corporations involved were operating at

a loss, some method of tax accounting must be
be available for this case of negative taxable
income.
To handle this possible situation, income tax
regulations permit the corporation to use the
loss to offset profits in other years by carry-
back or carry-forward of losses.

Tax laws permit a corporation to carry its

losses back as charges against profits for as
many as three years before the loss or, if
necessary, to carry the losses forward as
charges against profits for as many as five
years after the loss.
Taxes and Depreciation:

In determining the influence of depreciation

costs on income taxes, Depreciation costs
represent a deduction from taxable gross
earnings. Thus, if d is the depreciation cost for
the year and is the fractional tax rate.

Tax “credit” for depreciation = d

Funds set aside for depreciation, although they
represent a cost, normally go directly into the
corporation treasury.
If S represents the total annual income or
revenue and C represents the total annual costs
with the exceptions of depreciation and taxes,
Net annual cash flow to company after taxes
Excess-Profits Tax :
During times of national emergency, certain
types of business concerns can realize
extremely high income and profit.

This is true in particular for concerns

producing military necessities during wartime.

An excess-profits tax is levied on these profits.

In general, the amount of the tax to be paid is
based on the normal past earnings of a concern
or on the total capital investment.
Special provisions are made for new
corporations which do not have a normal past
history to use as a basis.
The excess-profits taxes are very unpopular
with businessmen, and there is always
considerable opposition to the levying of these
taxes.
Income Tax Returns:
Income-tax returns may be reported on a cash
basis or on an accrual basis.

When the cash basis is used, only money

actually received or paid out during the year is
reported.

With the accrual method, income and expenses

are included as of the time they were incurred,
even though final payment has not yet been
made.
OTHER TAXES:

The Federal Insurance Contribution Act levies

a social security tax on most employers and
also requires a certain percentage of
employees’ wages to be withheld.

Concerns doing business in foreign countries

must pay taxes based on the laws of the
foreign countries involved.
1) The fixed-capital investment for an existing chemical
plant is $20 million. Annual property taxes amount to
1 percent of the fixed-capital investment, and state
income taxes are 5 percent of the gross earnings. The
net income per year after all taxes is $2 million, and
the Federal income taxes amount to 34 percent of
gross earnings. If the same plant had been constructed
at a location where property taxes were 4 percent of
the fixed-capital investment and state income taxes
were 2 percent of the gross earnings, what would be
the net income per year after taxes, assuming all other
cost factors were unchanged?
2)During the period of one taxable year at a
manufacturing plant, the total income on a cash basis
was $21 million. Five million dollars of immediate
debts due the company was unpaid at the end of the
year. The company paid out $15 million on a cash
basis during the year, and all of this amount was tax-
deductible as a product cost. The company still owed
$3 million of tax-deductible bills at the end of the
year. If the total Federal income tax for the company
amounts to 34 percent of the gross earnings,
determine the amount of Federal income tax due for
the year on a cash basis and also on an accrual basis.
3) The gross earnings for a small corporation
were $54,000 in 1970. What would have
been the percent reduction in Federal income
taxes paid by the company if the tax rates in
effect in 1988 had been in effect in 1970? (See
Table 2 for Federal income-tax rules in effect.)
INSURANCE :
The annual insurance cost for ordinary
industrial concerns is approximately 1 percent
of the Fixed capital investment.

Though they represent only a small fraction of

total costs, it is necessary to consider insurance
requirements carefully to make certain the
economic operation of a plant is protected
against emergencies .
The design engineer can aid in reducing
insurance requirements if he or she
understands the factors which must be
considered in obtaining adequate insurance.

 The engineer should be aware of the different

types of insurance available and the legal
responsibilities of a concern with regard to
accidents.
LEGAL RESPONSIBILITY:

A concern can obtain insurance to protect itself

against loss of property owing to any of a
number of different causes.

In case a property loss occurs and the loss is

covered by insurance, payment will be made
for the damage even though the loss was
caused by the owner’s negligence.
Protection against unforeseen emergencies,
other than direct property loss, can also be
obtained through insurance.

For example:
Injuries to employees or persons due to a fire
or explosion.
It is, of course, impossible to insure against
every possible emergency, but it is necessary
to consider the results of a potential
occurrence, and the legal responsibility for
various types of events should be understood.

 The payments required for settling a case in

which legal responsibility has been proved
may be much greater than any costs due to
direct property damage.
An assumed liability is one which the concern
accepts in the form of a written contract or
statement.

Legal liability is always in effect whether or

not it is stated in writing.
Many contracts include hold-harmless
agreements wherein the legal responsibility
for an accident or other type of event is
indicated as part of a written agreement.

Any new lease or contract should be examined

by an expert to make certain all hold-harmless
agreements are clearly stated and understood
by both parties.
Any concern producing a product which may
be dangerous to life or property has a legal
responsibility to indicate the potential hazard
by use of warning labels or other protective
methods.
The manufacturer must supply safe shipping
containers and make certain that any hazards
involved in their handling or use are clearly
indicated.
Legal liability also holds for defective or
misrepresented products.
A manufacturing establishment may have
property which would be highly attractive as a
place for children to play.

Ex: quarry pit and a sand pile.

An object of this type is known as an attractive

nuisance, and the concern may be liable for
injuries to children if the injuries are a result of
their playing around the object.
The liability would apply even though the
children were obviously trespassing.

 High fences or some other effective safety

measure should be used to keep children from
gaining admittance to an attractive nuisance.
An industrial concern has a legal responsibility
for property belonging to others as long as the
property is on the concern’s premises. This
responsibility is known as a bailee’s liability.

The property may be stored equipment or

materials, finished products, or products in
process.
If the property is damaged or destroyed, the
bailee’s liability is roughly a function of the
degree of care used in safeguarding the
property.

In case the damaged or destroyed property is

insured by the owner, the insurance company
will pay the claim; however, the insurance
company can then exercise its subrogation
rights and attempt to force the bailee to pay
the full amount received by the owner.
TYPES OF INSURANCE:
1. Fire insurance and similar emergency coverage on buildings,
equipment, and all other owned, used, or stored property.
Included in this category would be losses caused by lightning,
wind- or hailstorms, floods, automobile accidents, explosions,
earthquakes, and similar occurrences.
2. Public-liability insurance, including bodily injury and property
loss or damage, on all operations such as those involving
automobiles, elevators, attractive nuisances, bailee’s charges,
aviation products, or any company function carried on at a
location away from the plant premises.
3. Business-interruption insurance. The loss of income due to a
business interruption caused by a fire or other emergency may
far exceed any loss in property. Consequently, insurance
against a business interruption of this type should be given
careful consideration.
4. Power-plant, machinery, and special-operations
hazards.
5. Workmen’s-compensation insurance.
6. Marine and transportation insurance on all
property in transit.
7. Comprehensive crime coverage.
8. Employee-benefit insurance, including life,
hospitalization, accident, health, personal
property, and pension plans.
Self-Insurance:

 On an average basis, insurance companies

pay out loss claims amounting to 55 to 60
cents for each dollar received. The balance is
used for income taxes , salaries, commissions,
administrative costs, inspection costs, and
various overhead costs.
Theoretically, a saving of 40 to 45 cents per
dollar paid for insurance could be achieved by
self-insurance.

If insurance requirements are great, this saving

could amount to a very large sum, and it would
be worthwhile to consider the possibilities of
self-insurance.
 The final decision to consider self insurance
should be based on the total loss involved if
the event or a series of such events were to
occur. But it should not be based on whether
or not the insurable event will occur, because
this is impossible to predict.
If an industrial concern has a number of
widespread interests and sufficient funds
available to handle simultaneous major losses
in several of these interests, it might be
reasonable to consider self-insurance on some
of the potential hazards. On the other hand, if a
single potential event could ruin the economic
standing of the company, it would be very
inadvisable to assume the risk involved in self
insurance.
There are several different ways of applying self-
insurance.

One method involves depositing money

equivalent to an insurance premium into a
special company fund. This fund can then be
used to handle any losses which may occur.
At the outset, this fund would be small and
would be inadequate to handle any major
losses. Consequently, if this method is used, it
may be necessary to supply an original base
fund until the fund has built up to a practical
value.
Under ordinary conditions, the premiums paid
into a self-insurance reserve are not tax-
deductible.
A second method may be used in which the
company assumes all the risk and no payments
are made into a reserve fund. This method is
designated as “self-assumption of risk.”

Partial self-insurance may be obtained through

the purchase of deductible insurance from
regular agencies. The purchaser assumes the
risk up to a certain amount and the insurance
company agrees to pay for any additional
losses.
Advantages of standard insurance :
1)The premiums for standard insurance are tax-
deductible( consider as expenses).

2)The inspection services supplied by the

insurance companies.These companies
require periodic inspections by specialists to
make certain that the insurance rates are
adequate, and the reports of these inspectors
often indicate new ideas or methods for
increasing the safety of the operation.
Q) Complete fire and allied-coverage insurance
for one unit of a plant requires an annual
payment of $700 based on an investment value
of $100,000. If income taxes over a 10-year
period average 30 percent of gross earnings, by
how much is the net income, after taxes,
reduced during this 10-year period owing to
the cost of the insurance?
Q)Self-insurance is being considered for one portion of a
chemical company. The fixed-capital investment involved is
$50,000, and insurance costs for complete protection would
amount to $400 per year. If self-insurance is used, a reserve
fund will be set up under the company’s jurisdiction, and
annual insurance premiums of $300 will be deposited in this
fund under an ordinary annuity plan. Al1 money in the fund
can be assumed to earn interest at a compound annual rate of 5
percent. Neglecting any charges connected with administration
of the fund, how much money should be deposited in the fund
at the beginning of the program in order to have enough
money accumulated to replace a complete $50,000 loss after
10 years?