What Is Tax Liability?

Tax liability is the payment owed by an individual, a business, or other entity to a federal, state, or local tax authority.

In general, a tax liability is incurred when income is earned and when income is generated by the sale of an investment or other asset. A local or state sales tax may be incurred when goods are purchased. (The U.S. does not levy a national sales tax although some countries do.)

It is possible for people to have no income tax liability if their total tax owed was zero or if their income was below the level that would require them to file tax returns.

Key Takeaways

  • Tax liability is the total amount of tax debt owed by an individual, corporation, or other entity to a taxing authority such as the Internal Revenue Service (IRS).
  • Income taxes, sales tax, and capital gains tax are all forms of tax liabilities.
  • Taxes are imposed by a variety of taxing authorities, including federal, state, and local governments, which use the funds to pay for services such as repairing roads and defending the country.
  • Both individuals and businesses can lower their tax liabilities by claiming deductions, exemptions, and tax credits.
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Tax Liability

Understanding Tax Liability

Taxes are imposed by a variety of authorities including federal, state, and local governments, which use the funds to pay for services such as repairing roads and defending the country.

When a taxable event occurs, the taxpayer needs to know the tax base for the event and the rate of tax on the tax base.

Sales tax and company payrolls are forms of tax liability. When businesses sell their products, many states and some local governments charge a sales tax, which is a percentage of each sale and is paid by customers. Businesses send the sales taxes they collect to taxing authorities monthly or quarterly. Companies withhold income taxes and taxes for Social Security and Medicare from employees' wages and send them to the federal government immediately.

An individual's or corporation's tax liability doesn't just include the current year. It factors in any and all years for which taxes are owed. That means that if there are back taxes (any taxes that remain unpaid from previous years) due, those are added to the tax liability as well.

Examples of Tax Liability

The most common type of tax liability for Americans is the tax on earned income. Assume, for example, that Anne earns $60,000 in gross income, which is reported on an IRS W-2 form at the end of the year. With a federal tax rate of 22% for that level of income, Anne's tax liability would be $8,949 based on 2020 tax brackets.

In particular, Anne would owe 10% on the first $9,950 of income, 12% on the next $30,575, and 22% on the last $19,475.

Assume that Anne's W-4 resulted in her employer withholding $6,500 in federal taxes and that she made a $1,000 tax payment during the year. When Anne files Form 1040, her individual tax return, the remaining tax payment due is the $8,949 tax liability less the $6,500 in withholdings and $1,000 payments, or $1,449.

Due to Hurricane Ida, some residents and business owners in Louisiana and parts of Mississippi, New York, Pennsylvania, and New Jersey have been granted extensions on their deadlines for filings and payments to the IRS. Most relate to upcoming due dates for quarterly filings and payments. For details, go to the IRS's "Tax Relief in Disaster Situations" page and click on "2021."

How Capital Gains Are Taxed

When a taxpayer sells an investment, real estate, or any other asset for a gain, that individual owes taxes on the gain.

Assume, for example, that Jamal purchases 100 shares of XYZ common stock for $10,000 and sells the securities five years later for $18,000. The $8,000 gain is considered to be the tax base for this taxable event. In this case, the transaction is a long-term capital gain since the stock was held for more than one year.

The tax rate for capital gains can be different from rates for income taxes and other tax calculations. If the tax rate is 10%, the tax liability is $800 and Jamal will include this calculation on his individual 1040 tax return.

Special Considerations: Line 16

Filled out your Form 1040? Line 16, which appears on page two of Form 1040, is your total tax liability to the IRS.

That sum might initially make your stomach turn because it can appear high. However, when your tax liability is calculated, you adjust it for federal income tax withheld, deductions, exemptions, and tax credits in order to compute the amount of taxes currently due and unpaid.

If you overpaid, you end up with a refund. On the other hand, if you paid too little, you'll owe the IRS some more.