Tax Expense

Tax Expense: Definition and Overview

A tax expense is the amount a person or business recognizes as owed to federal, state, or local taxing authorities for a given reporting period. For accounting purposes, it is reported on the income statement and reduces net earnings available to owners or shareholders.

How Tax Expense Is Calculated

• Basic concept: Tax expense ≈ effective tax rate × taxable income.
• Calculating taxable income requires applying tax code rules to pre-tax financial results, adjusting for items that differ between financial accounting (GAAP) and tax law.
• Because accounting and tax rules often diverge (for example, differences in allowable depreciation methods), the tax expense recognized in financial statements may not equal the actual tax payment due for the period.

Common adjustments and taxes that affect tax expense:
– Payroll taxes (employer portion)
– Income taxes (federal, state, local)
– Sales and excise taxes (where applicable)
– Taxes on gains (capital gains, corporate dividends, etc.)

Tax Expense vs. Tax Payable

• Tax expense: The accounting charge for taxes on the income statement.
• Tax payable: The actual amount due under the tax code, recorded as a current liability on the balance sheet until paid.
• Differences between the two create deferred tax items:
• Deferred tax liability: When tax expense > tax payable, indicating taxes will be paid in the future.
• Deferred tax asset: When tax payable > tax expense, representing potential future tax relief.

Why Differences Arise

Examples of timing and rule differences:
– Depreciation: GAAP may use straight-line depreciation for financial reporting, while tax law may allow accelerated depreciation, lowering taxable income early and creating temporary timing differences.
– Loss carryforwards: A company that reports a loss can carry forward that loss to offset future taxable income, reducing future tax expense.
– Jurisdictional variation: Different tax rates and rules across federal, state, and local jurisdictions affect effective tax rates.

Tax Expense for Individuals vs. Businesses

• Individuals: Tax expense generally equals the income taxes owed for the year (federal, state, local), reconciled on an annual return against taxes already paid (withholdings, estimated payments). Payroll taxes (FICA) and taxes on investment income also contribute.
• Businesses: More complex. Tax expense is based on net taxable income after allowable deductions and adjustments under tax law. Businesses must follow IRS rules and GAAP, which often require reconciling financial income to taxable income.

Special note on corporations:
– C corporations pay tax on corporate profits; shareholders may also pay tax on dividends, resulting in double taxation of corporate earnings.

Effect on Financial Statements and Shareholders

• Tax expense reduces pretax income to arrive at net income on the income statement.
• Lower net income can reduce earnings available for dividends and reinvestment.
• Deferred tax assets and liabilities appear on the balance sheet and affect future tax expense and cash flows.

Key Takeaways

• Tax expense is the accounting measure of taxes attributable to a reporting period and is reported on the income statement.
• It is determined by applying effective tax rates to taxable income, but accounting and tax rules can create differences between tax expense and actual taxes payable.
• Differences produce deferred tax assets or liabilities, reflecting timing differences between book accounting and tax payments.
• Calculating tax expense is straightforward in concept but can be complex in practice due to multiple taxes, jurisdictional differences, and differing accounting and tax treatments.