What Is a Tax Expense?
A tax expense is a liability owed to federal, state/provincial, and/or municipal governments within a given period, typically over the course of a year. Tax expenses are calculated by multiplying the appropriate tax rate of an individual or business by the income received or generated before taxes, after factoring in such variables as non-deductible items, tax assets, and tax liabilities.
Tax Expense = Effective Tax Rate x Taxable Income
- Tax expense is the total amount of taxes owed by an individual, corporation, or other entity to a taxing authority.
- Income tax expense is arrived at by multiplying taxable income by the effective tax rate.
- Other taxes may be levied against an asset's value, such as property or estate taxes.
Understanding Tax Expense
Calculating tax expense can be complex given that different types of income are subject to certain levels of taxes. For instance, a business must pay payroll tax on wages paid to employees, sales tax on certain asset purchases, and excise tax on certain goods. In addition to the range of tax rates applicable to various levels of income, the different tax rates in different jurisdictions and the multiple layers of tax on income also add to the complexity of determining an entity’s tax expense. Determining the appropriate tax rate and identifying the correct accounting methods for items affecting one's tax expense are carefully described by tax authorities such as the Internal Revenue Service (IRS) and GAAP/IFRS.
Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS) provide for a certain treatment of items of income and expenses which may differ from the provision allowed under the applicable government tax code. This means that the amount of tax expense recognized is unlikely to exactly match the standard income tax percentage that is applied to business income. In other words, the differences in financial accounting and the tax code may result in a tax expense that differs from the actual tax bill. For example, many companies use straight-line depreciation to calculate the depreciation reported in their financial statements, but are allowed to employ an accelerated form of depreciation to derive their taxable profit; the result is a taxable income figure that is lower than the reported income figure. Another example is bad debt write-off in which the government may have a stricter standard requiring the filing of claims in court.
Tax expense affects a company’s net earnings given that it is a liability that must be paid to a federal or state government. The expense reduces the amount of profits to be distributed to shareholders in the form of dividends. This is even more disadvantageous to shareholders of C corporations who must pay taxes again on the dividend received. However, a tax expense is only recognized when a company has taxable income. In the event that a loss is recognized, the business can carry its losses forward to future years to offset or reduce future tax expenses.
Tax Expense Vs. Tax Payable
The tax expense is what an entity has determined is owed in taxes based on standard business accounting rules. This charge is reported on the income statement. The tax payable is the actual amount owed in taxes based on the rules of the tax code. The payable amount is recognized on the balance sheet as a liability until the company settles the tax bill. If the tax expense is higher than the tax liability, the difference creates another liability, called a deferred tax liability, which must be paid at some point in the future. On the other hand, if the tax payable is higher than the tax expense, the difference creates an asset category, called the deferred tax asset, which can be used to settle any tax expense in the future.