A tax expense represents the liability owed to federal, state, or local governments over a given time period, typically on an annual basis. This article breaks down the concept of tax expenses for both individuals and businesses, including how they are calculated and their impact on financial statements.
Key Insights
- Tax Expense Defined: Tax expenses constitute the total amount of taxes due from an individual, corporation, or other entity to a taxing authority.
- Calculation: Income tax expense is determined by multiplying taxable income by the effective tax rate.
- Varying Taxes: Other taxes like property or estate taxes may also apply, against an asset’s value.
Understanding Tax Expenses
At its core, a tax expense is calculated by multiplying the effective tax rate by taxable income. However, this calculation is often complex due to the varying taxes that individuals and businesses encounter.
For example, a business must often pay multiple forms of taxes, such as:
- Payroll tax on employee wages
- Sales tax on certain purchases
- Excise tax on specific goods
Individuals face different income tax rates, with wages and FICA (Federal Insurance Contributions Act) contributions, which fund Social Security, Medicare, Medicaid, and unemployment insurance, being taxed separately.
Tax Rates and Jurisdictions
Different tax rates across varying jurisdictions complicate tax expense calculations. Moreover, businesses must adhere to accounting principles set out by the IRS and standardized by Generally Accepted Accounting Principles (GAAP). These standards impact how income and reasons are treated, and sometimes differ from provisions under government tax codes.
Because of these differences, the tax expense recognized may not always align with the standard income tax percentage applied to business income, creating distinctions between financial accounting records and tax obligations.
Financial Accounting vs. Tax Code
For instance, many companies use straight-line depreciation to calculate depreciation in financial statements but employ an accelerated method of depreciation for taxable income purposes. This divergence results in a taxable income lower than reported income.
The tax expense impacts a company’s net earnings as it is a liability owed to state and federal authorities, subsequently reducing profits available for shareholder dividends. This is particularly disadvantageous for C corporations, where taxes are levied on earned profits and shareholders are taxed on dividends received.
Tax Expense Recognition
A business only recognizes a tax expense when it has taxable income. If a loss occurs, the company can carry forward these losses to offset future tax expenses.
Distinguishing Tax Expense from Tax Payable
The tax expense is the calculated amount using standard business accounting rules, reported on the income statement. In contrast, tax payable denotes the actual amount owed based on the tax code and appears as a liability on the balance sheet until the bill is settled.
Deferred Tax Liabilities and Assets
When tax expense exceeds tax payable, it creates a deferred tax liability, an obligation to be settled in the future. Conversely, if tax payable exceeds tax expense, it forms a deferred tax asset, usable to offset future tax expenses.
Individual Taxpayer Tax Expenses
For individuals, a tax expense means the amount owed in federal, state, and local income taxes. This expense is reported annually in a tax return to resolve any differences between taxes already paid and those actually due.
Business Tax Expenses
For businesses, arriving at a tax expense is notably complex. Taxation is based on net income (revenue minus expenses) and requires compliance with IRS rules and GAAP standards to correctly record expenses for tax purposes.
Components of Federal Tax Expenses
An individual’s annual tax return includes their income and owed taxes across categories like:
- Earned income from salaries, wages, tips, and commissions
- Unearned income, such as capital gains or bond interest
- FICA payroll tax, deducted automatically from paychecks
Conclusion
A tax expense encompasses owing amounts to government bodies—federal, state, or local. It includes varied forms of taxes like capital gains, payroll, sales, and income taxes. Although calculations generally involve multiplying applicable tax rates by taxable income, exceptions like sales tax are calculated differently by applying the tax rate to the sales price of purchased goods or services.
Related Terms: income statement, tax payable, deferred tax liability, deferred tax asset, GAAP, income tax.
References
- Internal Revenue Service. “Publication 946, How to Depreciate Property”, Pages 9-10, 26.
- Internal Revenue Service. “Forming a Corporation”.
- Internal Revenue Service. “Publication 542, Corporations”, Pages 13-14.
