What Is a Deferred Tax Liability?

A deferred tax liability is a tax that is assessed or is due for the current period but has not yet been paid—meaning that it will eventually come due. The deferral comes from the difference in timing between when the tax is accrued and when the tax is paid. A deferred tax liability records the fact the company will, in the future, pay more income tax because of a transaction that took place during the current period, such as an installment sale receivable.

Key Takeaways

  • A deferred tax liability represents an obligation to pay taxes in the future.
  • The obligation originates when a company or individual delays an event that would cause it to also recognize tax expenses in the current period.
  • For instance, earning returns in a qualified retirement plan, like a 401(k), represents a deferred tax liability since the retirement saver will eventually have to pay taxes on the saved income and gains upon withdrawal.

Deferred Tax Liability

How Deferred Tax Liability Works

Because U.S. tax laws and accounting rules differ, a company's earnings before taxes on the income statement can be greater than its taxable income on a tax return, giving rise to deferred tax liability on the company's balance sheet. The deferred tax liability represents a future tax payment a company is expected to make to appropriate tax authorities in the future, and it is calculated as the company's anticipated tax rate times the difference between its taxable income and accounting earnings before taxes.

Simplifying Deferred Tax Liability

A simple way to define the deferred tax liability is the amount of taxes a company has "underpaid"—which will (eventually) be made up in the future. By saying it has underpaid doesn't necessarily mean that it hasn't fulfilled its tax obligations, rather it is recognizing that the obligation is paid on a different timetable.  

For example, a company that earned net income for the year knows it will have to pay corporate income taxes. Because the tax liability applies to the current year, it must also reflect an expense for the same period. But the tax will not actually be paid until the next calendar year. In order to rectify the accrual/cash timing difference is to record the tax as a deferred tax liability. 

Examples of Deferred Tax Liability Sources

A common source of deferred tax liability is the difference in depreciation expense treatment by tax laws and accounting rules. The depreciation expense for long-lived assets for financial statement purposes is typically calculated using a straight-line method, while tax regulations allow companies to use an accelerated depreciation method. Since the straight-line method produces lower depreciation when compared to that of the under accelerated method, a company's accounting income is temporarily higher than its taxable income.

The company recognizes the deferred tax liability on the differential between its accounting earnings before taxes and taxable income. As the company continues depreciating its assets, the difference between straight-line depreciation and accelerated depreciation narrows, and the amount of deferred tax liability is gradually removed through a series of offsetting accounting entries.

Another common source of deferred tax liability is an installment sale, which is the revenue recognized when a company sells its products on credit to be paid off in equal amounts in the future. Under accounting rules, the company is allowed to recognize full income from the installment sale of general merchandise, while tax laws require companies to recognize the income when installment payments are made. This creates a temporary positive difference between the company's accounting earnings and taxable income, as well as a deferred tax liability.

Frequently Asked Questions

What is a deferred tax liability?

Deferred tax liability represents taxes that must be paid at a future date. For instance, if a company realized a taxable expense within a current period but hasn’t paid taxes on them, they are obligated to pay this tax expense at a later period. Deferred tax liabilities are often the result of companies operating two different sets of books, one for financial purposes and the other for tax purposes. Typically, rules that dictate the depreciation of assets, valuing inventories, or recognizing revenues often differ between these two books.

What is an example of a deferred tax liability?

The depreciation of fixed assets is a common example that leads to a deferred tax liability. Usually, a company will report depreciation in their financial statements with a straight-line depreciation method. Essentially, this evenly depreciates the asset over time. By contrast, for tax purposes, the company will use an accelerated depreciation approach. Using this method, the asset depreciates at a greater rate in its early years. A company may record a straight-line depreciation of $100 in its financial statements versus an accelerated depreciation of $200 in its tax books. In turn, the deferred tax liability would equal $100 multiplied by the tax rate of the company.

How is deferred tax liability calculated?

One other example of deferred tax liability is in how revenue is recognized. Consider a company that sold a $1,000 piece of furniture with a 20% tax rate, which is paid for in monthly installments by the customer. The customer will pay this over two years ($500 + $500). For financial purposes, the company will record a sale of $1,000. Meanwhile, for tax purposes, they will record it as $500. As a result, the deferred tax liability would be $500 x 20% = $100.