Income taxes can sometimes be confusing, and a deferred tax liability is one of those confusing situations.
Have you ever heard of owing a tax now but not being legally required to pay it until later? Since tax laws and accounting rules sometimes follow different timetables, this situation happens more often than you realize.
You encounter it when calculating business taxes, not individual tax returns. If you are wondering how to calculate a deferred tax liability and how it might affect you, keep reading.
We will tell you everything you need to know about these future tax payments and how they might affect you.
What Is A Deferred Tax Liability?
A common question regarding taxes is, “What is deferred tax liability?” A deferred tax liability occurs when you owe taxes on taxable income, or those taxes are due in the current period, but you have not yet paid those taxes.
Rest assured that the tax will ultimately have to be paid at some time in the future. This happens because accepted accounting standards allow you to accrue the tax in the current period, but the IRS may not require tax payment until a future date.
The law allows these businesses to maintain two separate books, one for accounting and one for tax purposes.
It is also a way for a company to report on its balance sheet that it will be paying additional taxes in the future for transactions that occurred in the current or previous year.
Eventually, the numbers on the financial statements will balance out, and the taxes will be paid. Deferred tax liabilities are only temporary differences in the financial reporting of the amount of tax due. This amount will ultimately be paid, and the financial reporting will sync.
Let us look at a simple example to help explain a deferred tax liability. If a business reports net income during the current year, everyone knows you will owe taxes on the income generated.
However, the tax will not be paid until next year. The business will report a deferred tax liability on its books for the current year to show the timing difference between the liability accrual and actual payment.
KEY TAKEAWAYS
- Deferred tax liabilitys are typically associated with businesses that own and depreciate assets. There may be a difference between tax and accounting reporting on their books.
- A business may have either a Deferred Tax Liability or Asset. A tax liability means they owe additional taxes in future years, while a tax asset means they are due a tax credit in future years.
- Business record these deferred tax entries on their balance sheet, which has an impact on their company cash flow.
What Are Deferred Tax Assets?
A deferred tax asset is basically the direct opposite of a deferred tax liability. Instead of reporting a future income tax expense, the business might need to report a future tax refund on its income statement.
- Perhaps they overpaid their taxes and will be due a refund in the future. The deferred tax accounting rules allow the business to report that amount as an asset.
- Just like with a deferred tax liability, the cash flows with deferred tax assets will eventually balance out in the financial accounting in future years.
Remember that the accounting principles in the corporate tax world are often more complicated than your individual tax reporting.
You may claim the due tax benefit on your accounting records now, but you might not receive the actual refund until later.
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Effect Of Deferred Tax Liability On Income Taxes
Deferred tax liabilities have no effect on how income taxes are calculated or the amount of tax that will be due.
However, deferred tax liabilities and assets can significantly impact your balance sheet and other financial reporting of these tax consequences.
The Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) can help explain how these liabilities or assets affect your business. The biggest impact that they will have on your business is the impact on cash flow.
These events can only be reported on your financial statements if they are “more likely than not” to occur. Any change in the likelihood of their occurrence might mean that you need to amend your reporting and update those financial records as soon as the next reporting period.
You might wonder, “Do I have to file taxes to report a deferred liability?” Yes, you should still file taxes like usual. The deferred portion will appear more obviously in your accounting books, and your tax books should not see any big changes in how your taxes are calculated.
TIP
GAAP and IFRS are the agencies that regulate business financial reporting. If you have questions regarding deferred tax liability/assets, you should review their guidelines. Tax accounting is different from business accounting, necessitating keeping two sets of financial records.
Deferred Tax Liability Examples
Many people wonder how to calculate deferred tax liability. It is generally calculated in the accounting books based on the amount of tax that will become due.
Deferred Tax Liabilities
The most common thing that can cause you to incur a deferred tax liability is how companies calculate depreciation – particularly for long-lived depreciable assets.
- Accounting rules and tax laws allow the depreciation valuation to be calculated using different depreciation methods.
- The accounting rules generally require the straight-line depreciation method to be used in the calculation; however, the tax laws allow for an accelerated depreciation method.
- The straight-line depreciation method computes lower depreciation, meaning the company’s income is often temporarily higher than the income reported for tax base purposes.
An installment sale is another common situation that generates a deferred tax. The company can report the income of the entire sale for general merchandise. This means that their income reported is temporarily higher than their actual receivables. This creates a deferred tax liability, where the tax will eventually come due and be paid.
Deferred Tax Assets
On the opposite end of the spectrum, a common reason for generating a deferred tax asset is the carry-forward of operating losses from the current year.
- These losses are often tax deductible, and businesses are often allowed to carry them forward to reduce their tax liabilities in future years.
- This can reduce the tax balances owed in those years, thus creating a deferred tax asset in the current year.
Personal Finance
Your personal finances can technically have deferred tax liabilities, too. However, they are not treated the same as businesses.
Think about your 401k, for example. Contributions are made to your account on a pretax basis. However, you will eventually owe taxes on those contributions and the gains on them when withdrawals are made.
This technically creates a deferred tax liability because that tax will be due, and you will have to pay it at some point in the future.
The Bottom Line
Deferred income tax liabilities are most common in the corporate world, although they can also be found in some personal tax situations.
One of the most common causes is the allocation of tax depreciation vs accounting depreciation. The difference in the timing of this item can lead to tax liabilities that may be owed because of current transactions but might not be paid until some point in the future.
You might also encounter deferred tax assets, which result from tax credits becoming due and are not received until some point in the future.
These situations can be complex and confusing, and you should always seek the advice of a qualified accountant if you have any questions about the specifics.
Frequently Asked Questions
Deferred tax liability is created when a tax is owed or due now because of situations in the current tax year, but the tax will not be paid until some point in the future.
The timing of these events does not always match precisely when comparing the accounting rules and the tax laws. Therefore, an entry may need to be made on the balance sheet showing that the tax will be paid in the future, but it may be some time before it is paid.
That entry showing the difference in timing is called a deferred tax liability.
So, what is deferred income tax, and how can you identify it in the books? If you are analyzing the balance sheets or income statements for a company, there are a few things that you can look for to recognize a deferred tax liability.
First, examine and read the footnotes for all the book entries. These notes can often be a dead giveaway to identifying a deferred tax liability.
Next, look at the company’s policy on capitalizing and depreciating fixed assets. Depreciation calculations often show a deferred tax liability.
Also, look at the company policy on amortizing assets. Amortization schedules are another area where you might encounter a deferred tax situation.
These liabilities can significantly impact a business’s cash flow. An increase in deferred tax liability amounts to more cash flow in the current year.
However, investors also watch out for these situations. You do not want your company to appear to have more debt than it can handle.
Deferred tax liabilities and assets can make the company’s cash flow appear overstated or understated, depending on the situation.
If these situations are not reported properly, an investor might decide not to invest in your company.
According to the IRS tax laws, it depends on when the tax is due. Generally, a deferred tax liability is paid the following year.
In some cases, like the depreciation of a long-term fixed asset, the deferred tax liabilities may compound on each other for several years. While the company might pay some of these liabilities each year, it might take several years before the deferred liability has evened out on the books.
Many ask, “How long do I have to keep my tax returns?” Since these taxes are paid later than they are owed, you might have to keep your records a little longer than usual.
The amount of time you keep them will likely be based on when the tax was paid instead of when you filed your return.
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