Tax Expense: Definition, Calculation, and Effect on Earnings

What Is a Tax Expense?

tax expense is a liability owed to a federal, state, or local government within a given time period, typically over the course of a year.

Tax expenses are calculated by multiplying the tax rate of the 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

Key Takeaways

  • Tax expenses are the total amount of taxes owed by an individual, corporation, or other entity to a taxing authority.
  • Income tax expense is calculated 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 Expenses

Calculating tax expense can be complex given that businesses and individuals are subject to various taxes, each set at a different rate. For instance, a business must pay payroll tax on wages paid to employees, sales tax on certain purchases, and excise tax on certain goods. An individual pays different income tax rates for wages and for their FICA contribution, which goes to Social Security, Medicare, Medicaid, and unemployment insurance. (FICA, which is virtually never spelled out, stands for Federal Insurance Contributions Act.)

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 add to the complexity of determining an entity’s tax expense.

In the U.S., determining the appropriate tax rate and identifying the correct accounting methods for items affecting business tax expense are detailed by the Internal Revenue Service (IRS) and are standardized by Generally Accepted Accounting Principles (GAAP).

The GAAP standards provide for a certain treatment of income and expenses which may at times differ from the provisions 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 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.

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 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.

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 later tax expenses.

Tax Expense vs. Tax Payable

The tax expense is the amount of money that a business or other entity has determined is owed in taxes based on standard business accounting rules. This charge is reported on the business' 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.

What Is a Tax Expense for an Individual Taxpayer?

For most individuals, a tax expense is the amount of money owed to the federal government and, for residents of all but nine states, to the state government, in annual income taxes.

This tax expense is reported annually in a tax return in which the individual resolves the difference between the amount of taxes already paid and the amount that was owed.

The key number in that tax return is the individual's calculation of taxable income, which determines how much tax is owed for the year. Individuals can legally reduce their taxable incomes by deducting some expenses. In recent years, many of those deductions have been abolished and the standard deduction has greatly increased.

As a result, nearly 90% of Americans take the standard deduction, greatly reducing the amount of paperwork needed to record and prove their taxable income.

What Is a Tax Expense for a Business?

Arriving at a tax expense is generally a much more complicated and time-consuming matter for businesses than for individuals.

A business is taxed on its net income. That is, it deducts the costs of doing business from the amount of revenue it takes in to arrive at its tax expense for the period.

Recording business expenses properly for tax purposes requires following rules set by the IRS and standards called GAAP for Generally Accepted Accounting Principles.

What Do My Federal Tax Expenses Include?

Your annual tax return reports your income for the year and the taxes you owe in a number of categories including:

  • Earned income including salary, wages, tips, and commissions.
  • Unearned income such as capital gains on the sale of stock or interest on bonds.
  • The FICA payroll tax, which funds Social Security, Medicaid, Medicare, and unemployment insurance. Like income tax, your estimated FICA tax is deducted from your paycheck at a tax rate of about 7.6%.

The Bottom Line

A tax expense is an amount of money that a business or an individual owes to a government body, whether it is federal, state, or local. The term covers all taxes, including capital gains taxes, payroll taxes, and sales taxes as well as income taxes.

Each of these taxes has its own tax rate, which is used to calculate the amount owed. In most cases, this is a simple matter of multiplying the applicable tax rate by the taxable income of the business or individual.

A notable exception, of course, is the sales tax. The amount of sales tax owed is calculated by multiplying the applicable tax rate by the sales price of the goods or services being purchased.

Article Sources
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  1. Internal Revenue Service. "Publication 946 (2019), How to Depreciate Property."

  2. Internal Revenue Service. "Forming a Corporation."

  3. Internal Revenue Service. "Publication 542: Corporations," Pages 14–15.

  4. Social Security Administration. "What Is FICA?"

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