# Taxable Income

In Step 2, we projected the tax rate as 40%, a round number approximation of the MRY tax rate. We still like our round, 40% all-in tax rate, but will bifurcate taxes into federal and state/local taxes in this step. Assuming a 3% state/local tax rate, we manually dial in a federal tax rate that targets a combined tax rate of 40%. Then, we replace the projected tax rate assumptions on the income statement with the new ones from our tax schedule. It will become clear why we are doing this in the next two steps.

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Taxable income computed for tax purposes differs from income before tax computed for book purposes because (a) cash accounting is used for tax purposes and accrual accounting is used for book purposes, and (b) the recognition of certain expenses differs for tax and book purposes (as we observed with MACRS depreciation in Step 12). We have already computed income before tax on the income statement. Now, we begin our calculation of taxable income with EBITDA, implying that all income statement items above EBITDA (e.g. sales, COGS, SG&A) are the same for tax and book purposes. This is generally a safe assumption.

In computing taxable income, we subtract expenses from and add income to EBITDA, similar to how we already computed income before tax on the book P&L. However, some of the items we add and subtract may be different for tax and book purposes. For example, we subtract the tax depreciation expense computed in Step 12 (although we assumed it is equal to book depreciation expense). Also, rather than adding all income from equity investments as we did on the book P&L, we only add the portion of those earnings distributed as cash for tax purposes. We assume that tax amortization of intangible assets equals book amortization for simplicity, and because we have no basis for assuming otherwise without further diligence.

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