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 legally not being required to pay it until later? Since the tax laws and accounting rules sometimes follow different timetables, this situation happens more than you might realize. It is generally something that you encounter when calculating business taxes and not individual tax returns. If you are wondering how to calculate a deferred tax liability and how it might affect you, then keep reading. We will tell you everything that you need to know about these future tax payments and how they might affect you.
What Is A Deferred Tax Liability?
A common question when it comes to 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. The way this happens is often due to the fact that accepted accounting standards allow you to accrue the tax in the current period, but the IRS may not require payment of the tax until a future date. In fact, the law allows these businesses to maintain two separate sets of books – one for accounting purposes and one for tax purposes.
It is also a way for a company to report on their balance sheet that they will be paying additional taxes during a future period for transactions that occurred during the current period. 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 get paid and the financial reporting will be in sync.
Let us take a look at a simple example to help explain a deferred tax liability. If a business reports net income during the current year, everyone knows that taxes will be due on that income at the current tax rate. However, the tax will not be paid until next year. The business will report a deferred tax liability on their books for the current year to show the timing difference in the accrual of the liability and the actual payment.
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 their income statement. Perhaps they overpaid their taxes and will be due a refund at a future time. 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. The tax benefit that is due may be claimed on your accounting records now, but you might not receive the actual refund until sometime in the future.
Effect Of Deferred Tax Liability On Income Taxes
Deferred tax liabilities really have no effect on the way your income taxes are calculated or the amount of tax that will be due. However, deferred tax liabilities and assets can have large impacts on 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 can 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 be wondering, “Do I have to file taxes to report a deferred liability?” Yes, you should still file taxes like normal. The deferred portion will show up more obviously on your accounting books, and your tax books should not see any big changes in the way your taxes are calculated.
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. The most common thing that can cause you to incur a deferred tax liability is the way that companies calculate depreciation – particularly for long-lived depreciable assets. Accounting rules and tax laws allow for the valuation of the depreciation to be calculated using different depreciation methods. The accounting rules generally require the straight line method of depreciation to be used in the calculation; however, the tax laws allow for a method called accelerated depreciation. The straight line depreciation method computes lower depreciation, so this means that 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 is allowed to report the income of the entire sale for general merchandise. This means that their income that gets reported is temporarily higher than their actual receivables. This creates a deferred tax liability where the tax will eventually come due and get paid.
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 those losses forward in order to reduce tax liabilities in future years. This can reduce the tax balances that are owed in those future years, thus creating a deferred tax asset in the current year.
When it comes to your personal finances, you can have deferred tax liabilities there too. 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 be found in some personal tax situations as well. 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 that are the result of tax credits becoming due that 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
How is deferred tax liability created?
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 do not always match exactly when comparing the accounting rules and the tax laws. Therefore, an entry may need to be made on the balance sheet showing the fact that the tax will be paid in the future, but it may be some time before it must be paid. That entry showing the difference in timing is called a deferred tax liability.
How do you identify deferred tax liability?
So, what is deferred income tax and how can you identify it on 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, be sure to examine and read the footnotes for all the entries in the books. 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 are often where a deferred tax liability will show up. Also, look at the company policy on amortizing assets. Amortization schedules are another area where you might encounter a deferred tax situation.
What is the impact of deferred tax liability?
These liabilities can have a big impact on the cash flow of a business. 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 as if it has more debt than it can handle. Deferred tax liabilities and assets can cause it to appear as though the company’s cash flow is overstated or understated depending on the situation. It might cause an investor to decide not to make an investment in your company if these situations are not reported properly.
When do you have to pay deferred tax liabilities?
It depends on when the tax is due according to the IRS tax laws. Generally, a deferred tax liability is paid the next 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 people 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 end up keeping your records a little longer than normal. The amount of time that you keep them will likely be based on when the tax was actually paid instead of the date you filed your return.