Deferred Tax Liability Explained for Accountants and Business Owners

Deferred tax liability is a common concept in accounting, but it can be confusing for many business owners and accountants. It arises when a company recognizes a taxable profit or loss in its financial statements, but not in its tax return.

This mismatch can occur due to differences in accounting and tax treatments of certain transactions, such as depreciation and amortization. For example, a company may claim a larger depreciation expense for tax purposes than for accounting purposes.

The deferred tax liability is the amount of tax that the company expects to pay in the future when it recognizes the taxable profit or loss in its tax return. It is not a current tax liability, but rather a future obligation.

A deferred tax liability can be a significant amount, and it's essential for accountants and business owners to understand how it works and how to manage it effectively.

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Calculating Deferred Tax Liability is a straightforward process that helps you understand the discrepancy between book and tax accounting.

A deferred tax liability can arise from temporary timing differences, such as lower payments to the IRS compared to book purposes, as seen in the example of a company with a cumulative depreciation expense of $35 million and a total cumulative tax expense of $20 million.

The formula used to calculate the deferred tax liability (DTL) is based on the difference between the value of PP&E under book accounting and tax accounting in each period multiplied by the tax rate.

For instance, if a company sells a piece of furniture for $1,000 plus a 20% sales tax, payable in monthly installments by the customer, the deferred tax liability would be $500 x 20% = $100, as calculated in the example of the company's financial records.

The deferred tax liability can be calculated by identifying the temporary timing differences between book and tax accounting, such as the discrepancy in tax payments to the IRS.

A deferred tax liability is created when a company pays less in taxes to the IRS than the tax expense recorded on its income statement under GAAP accounting standards. This is because of a temporary timing mismatch between the recognized tax expense and the actual taxes paid.

The discrepancy arises when a company recognizes full income from an installment sale, for example, while tax laws require it to recognize the income when installment payments are made. This creates a temporary positive difference between the company's accounting earnings and taxable income.

A deferred tax liability can also arise from the difference in depreciation recognition policies between GAAP and tax purposes. For instance, a company may use straight-line depreciation for GAAP reporting, but accelerated depreciation for tax purposes. This results in a greater depreciation expense for tax purposes in the earlier stages of the fixed asset's useful life.

The deferred tax liability is calculated as the company's anticipated tax rate times the difference between its taxable income and accounting earnings before taxes. It represents a future tax payment the company must make to rectify the accrual/cash timing difference.

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Here's a comparison between Deferred Tax Liability and Deferred Tax Asset:

A company with significant deferred tax liabilities has already tapped into tax breaks and may need additional cash on hand to pay taxes in future tax years.

Deferred tax liabilities are recorded at their full amount, which means a company will show the entire amount it owes in taxes on its balance sheet.

This is in contrast to deferred tax assets, which are offset by a valuation allowance that reflects the possibility the asset will expire before the company can use it.

The amount of the valuation allowance is highly subjective and left to management's discretion, making it a key decision point for companies with deferred tax assets.

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Deferred tax liability is a record of taxes incurred but not yet paid, which reduces the cash flow a company has available to spend.

This line item on a company's balance sheet is a known future expense that has been earmarked for a specific purpose: paying taxes the company owes.

If a company spends the money set aside for taxes on anything else, it could be in trouble.

The U.S. Securities and Exchange Commission notes that taxes are a significant expense for companies, and deferred tax liability is a way to account for these future tax payments.

Deferred tax liability is a reserve of money that's not available for other uses, which can impact a company's cash flow and spending decisions.

According to Financial Accounting Standards, deferred tax liability is a liability account that represents the amount of taxes that a company has incurred but not yet paid.

Here are some key characteristics of deferred tax liability:

The Internal Revenue Service notes that business taxes are a significant expense for companies, and deferred tax liability is a way to account for these future tax payments.

Virtual certainty is crucial for recognizing a Deferred Tax Asset (DTA). A company must have a future virtual certainty to recognize a DTA.

To determine virtual certainty, a company must reliably estimate sufficient future taxable income. This can be achieved through convincing evidence such as projected future profits based on sales estimates and future restructuring.

However, a binding export order that may get cancelled anytime does not constitute virtual certainty. Virtual certainty is based on projects that are likely to happen in the future.

A company must perform a virtual certainty test every year to assess its DTA. If the conditions are not met, the DTA must be written off.

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A deferred tax liability can arise from temporary timing differences between financial records and tax records.

Temporary timing differences can result in lower payments to the IRS compared to the amount recorded for book purposes.

The deferred tax liability can reverse course as tax payments to the IRS become higher to compensate for the discrepancy.

A company might sell a piece of furniture for $1,000 plus a 20% sales tax, payable in monthly installments by the customer.

The deferred tax liability would be $100, calculated as $500 x 20%.

The cumulative depreciation expense is $35 million, while the total cumulative tax expense is $20 million under both book and tax accounting.

This highlights the importance of accurate accounting and tax calculations to avoid discrepancies.

A deferred tax liability is essentially an obligation to pay taxes in the future. This occurs when a company or individual delays an event that would normally cause them to recognize tax expenses in the current period.

For individuals, earning returns in a 401(k) is a great example of a deferred tax liability. You'll pay taxes on the saved income and gains at withdrawal.

Here are the key takeaways to remember:

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A deferred tax liability is a real thing, and it's not just for big companies. A deferred tax liability represents an obligation to pay taxes in the future.

Here's a key takeaway: earning returns in a 401(k) is a great way to save for retirement, but it also means you'll have a deferred tax liability when you withdraw the funds.

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For individuals, a deferred tax liability can be created when you delay paying taxes on income or gains. This can happen when you invest in a 401(k) or other retirement account.

A deferred tax liability can be a good thing in the long run, but it's essential to understand how it works. The key is to recognize that you'll pay taxes on the saved income and gains at withdrawal.

Here are some key takeaways to keep in mind: