Understanding the basic underpinnings of your taxes allows you to develop better financial literacy. In turn, you can more accurately anticipate what taxes you will owe at the end of the year—instead of being met with an unpleasant surprise in the form of a momentous tax bill when it’s time to file. Your tax liability, in its most basic definition, is what tax amount you owe to the IRS at the close of a given tax year.
Your full tax liability is influenced by a variety of different factors and the filing process changes if you’re filing as an individual or a business. The tax liability you may be most familiar with is your individual income tax, but there are several different kinds of liabilities that may impact what money you owe or, alternatively, if you’re owed a refund.
Below, we’ll dive into the different kinds of tax liabilities and how to reduce your own tax liability. Keep reading for a complete explanation or jump to the link most relevant to your query.
- What is Tax Liability
- Types of Tax Liability
- How to Determine Tax Liability
- How to Reduce Your Tax Liability
- Paying Your Tax Liability
- Working with a Professional
What is Tax Liability?
Your tax liability is the full amount of taxes you owe to the IRS at the end of the tax year and applies to both individuals and businesses. Tax liabilities accrue when you earn income, or another kind of “taxable event” occurs, like issuing payroll or selling off your stock holdings for a profit.
Your regular wage earnings for a job also create a tax liability. In most cases, employers withhold portions of wages in order to cover an individual’s liabilities. But if the amount withheld doesn’t cover your total liability for the year, you are required to make up the difference by paying the remainder. On the other hand, if the amount withheld exceeds your total tax liability, you get a tax refund. If you don’t have a tax liability at all, that means your total tax was zero the prior year or, you didn’t need to file a tax return.
Tax liabilities include, but aren’t limited to:
- Income taxes
- Sales tax
- Capital gains tax
- Social Security tax
- Medicare tax
- Unemployment tax
We’ll explore the intricacies of these types of tax liability scenarios in depth below.
Types of Tax Liabilities
Taxes are imposed on a federal, state, and local level and help pay for public projects like rebuilding infrastructure and funding public programs. As we touched on previously, there are a variety of tax liabilities that may apply to your personal or company tax situation. It’s important to understand which may apply to you, so you can better anticipate your final tax bill.
Sales Tax Liability
Sales tax is a common type of tax liability you’ve likely paid for when shopping. When a company sells a product or service, many state and local governments charge a sales tax. A sales tax is a percentage of each sale, paid by the consumer. Businesses must remit sales taxes to tax authorities on a quarterly or monthly basis.
Payroll Tax Liability
If you own a company and employ workers, you must withhold, file, and send in payroll taxes. In addition, you must also remit employer taxes. The amount you withhold from employees plus the money you spend as the employer determine the payroll taxes you owe.
Taxes that need to be withheld include income taxes (federal, state, and local), FICA taxes, and federal and state unemployment taxes. As a note, FICA taxes make up what employers contribute in Social Security tax and Medicare tax, which is imposed on employee earnings.
Back Taxes Liability
An individual or company’s tax liability isn’t limited to the current year. Rather, it includes all the years for which taxes are still owed. For example, if you owe back taxes, those are added to your total tax liability.
Property Tax Liability
If you own property, you’ll be responsible for paying a property tax to your local government. These taxes vary based on location and the rates are reassessed every year.
Income Tax Liability
This is the type of tax liability you’re probably already familiar with because you likely file income taxes each year. Let’s take a look at a real-world scenario of income tax liability.
Josh earned $70,000 in gross income last year. Those earnings are reported on a W-2 form, which is mailed to him at the end of the year. He will pay a federal tax rate of 22% based on his tax bracket. So, to compute his full tax liability for his income, he would use the following equation:
- Income x Tax Rate = Tax Liability
- $70,000 x 0.22 = $15,400
So, as you can see, his income tax liability would be $15,400. With that said, let’s assume that Josh’s W-4 shows that his employer withheld $12,000 in federal taxes and he made another $2,000 in tax payments during the year. When Josh files his taxes, he will owe $15,400 minus his withholdings and tax payments.
To see his remaining income tax liability after taking out the taxes he’s already paid, Josh can use the following equation:
- Total Tax Liability – (Employer-Withheld Taxes + Individual Tax Payments) = Remaining Income Tax Liability
- $15,400 – ($12,000 + $2,000) = $1,200
As a result, Josh’s final remaining tax liability is $1,200. Of course, that doesn’t include any deductions or tax credits that can influence the final tax amount due.
Capital Gains Tax Liability
If you have an investment like stocks or real estate but sell it at a profit, you’ll need to pay taxes on the gains. For example, let’s say you bought a stock for $5,000 and after three years, you sell it at its accrued value for $10,000. In this instance, you would be required to pay taxes on that $5,000 gain.
It’s important to note that the tax rate for capitals gains may be different from other tax calculations. If you’re not sure, it’s best to consult a tax professional steeped in this particular kind of tax knowledge.
Self-Employment Tax Liability
As you read above, employers are responsible for withholding certain amounts of income to cover the employees’ tax liabilities. But what happens if you’re your own employer? If you’re self-employed, you’re responsible for paying for your taxes on income that would normally be withheld by your employers. Self-employed workers pay a self-employment tax that covers your Social Security and Medicare taxes.
A self-employment tax liability is equal to 15.3% of your net income. You can pay your self-employment taxes through estimated tax payments throughout the year, however. This helps you avoid a big tax bill at the end of the year.
What is Deferred Tax Liability?
If you own a business, you might be on the hook for another kind of tax liability: deferred tax liability. So, what is deferred tax liability?
Deferred tax liability, also known as DTL, refers to the tax owed by a business that has not yet been resolved or paid. In most instances, this occurs because of the discrepancy between business accounting methods and tax structures.
For example, let’s say your business uses accrual-based accounting, like most companies do. If that’s the case, then you might have revenue that’s been billed during the present tax year, but your company doesn’t actually get those earnings until the next tax year.
The IRS’ solution to this is to allow companies to defer their taxes to the time when those anticipated earnings are actually obtained.
The reasons why a business may have a deferred tax liability include:
- Assets depreciating in value, so there is a difference between accounting earnings and taxable earnings.
- Credit sales that result in a later revenue-earning date.
- Installment sales, which result in sales revenue that is billed, but not yet earned.
DTL impacts your business because it forces you to consider how each expense and kind of income affects your company’s overall financial standing. DTL is a tax debt you are still required to pay at a future date, so it’s critical to plan for these expenses to ensure your books are balanced.
It’s important to note that DTL isn’t necessarily a bad thing and it doesn’t mean you didn’t pay enough taxes, it’s just one consideration you’ll need to make when you’re actively managing your business finances.
For example, perhaps you anticipate you’re going to owe deferred taxes. In that case, it’s a good idea to start paying down other debts to balance out both your assets and liabilities. Doing so will help set your business up for the possibility of growth, rather than going down a potential path of bankruptcy if you fail to take deferred tax liabilities into account properly.
In order to calculate your deferred tax liability, you can use the formula below:
- DTL = Income Tax Expense – Taxes Payable + Deferred Tax Assets.
But remember, when you’re calculating what deferred taxes you owe, make sure that you verify the current tax and depreciation rates that apply to your company. If the tax rate goes up, your DTL should reflect that. In terms of your business accounting, that means you’ll need to budget more money in the future to balance out the increased liabilities on the books.
If you don’t have a business accountant but you want your taxes to be accurate, hiring a professional is an important step. Knowing your income, revenue, liabilities, and assets is a huge part of understanding your company’s financial big picture. Small business accounting services can help you better track your company’s finances and keep track of your tax liabilities.
How to Determine Tax Liability
America uses a progressive tax system that has seven income tax rates, from 10% to 37%. Your filing status also puts you into a particular tax bracket and shows what rates you owe on your earnings based on your individual or joint income as a couple. The tax amount calculated from this determines your tax liability, but not necessarily what taxes you actually owe the IRS.
If you have your Form 1040 already, you can just go to Line 22, which will read, “Amount you owe.”
How to Reduce Tax Liability
The number you see after calculating your tax liability is likely much larger than what you’ll actually pay to the IRS. This is because you can reduce your taxable income through a series of different deductions. For example, one common deduction is the straightforward standard deduction.
For the 2019 tax year, the standard deduction for single taxpayers is $12,200. That means, if you earned $70,000, your taxable income would drop to $57,800 after the standard deduction is applied.
There are also other income adjustments that may apply to your taxes, as well. Deductions you claim are included as additions to the standard deductions or itemized deductions. Common deductions include the following:
- Mortgage interest deduction
- Student loan interest deduction
- Charitable donation deduction
- Retirement funds deduction (IRA or 401(k))
- Self-employment expenses deduction
- Home office deduction
- Educator expenses deduction
Tax credits can also reduce your total tax liability. What’s the difference between tax credits and tax deductions? Well, deductions decrease what amount of income you can be taxed on and tax credits decrease what you actually owe the IRS directly.
For example, if you’ve calculated your taxes and you’ve included all the deductions that can apply to you but find that you still have a $5,000 tax liability, you can still reduce that amount. Let’s say you’re eligible for $2,000 in tax credits. That means you’ll only owe $3,000 to the IRS. The tax credits act as a stand-in for an actual payment to the IRS, so it wipes away a portion of the final amount of taxes due.
Common tax credits include:
- Earned income tax credit
- Child tax credit
- Child and dependent care tax credit
- Adoption tax credit
- Foreign tax credit
And, if your tax credits leave you with a negative amount owed, the IRS will cut you a check for the difference, in the form of a refundt. You’ll also get a tax refund if you overpay your taxes during the course of the tax year, which can happen if you overestimate your tax liability.
Paying Your Tax Liability
It’s important to pay your taxes as quickly as possible. Otherwise, you open yourself to a series of tax penalties. This applies to both individual and company tax liabilities.
Although you can file on your own, taxes can be complicated to understand and fully unpack. You may miss deductions or tax credits that are applicable to your taxes. In order to make the most of your taxes and aim for the biggest reduction of your taxable income, it’s typically worth the expense to pay for tax preparation services.
Working with a Professional
Using a professional to keep track of your taxes and prep your taxes offers many potentially lucrative benefits.
Potential benefits of using a tax professional for your taxes include:
- Saves you time: Instead of being forced to pore over the intricacies of your taxes, a professional who’s vetted and experienced can cut down on the time it takes to get your taxes done. The IRS reports that it takes around 20 hours for an individual to complete a tax return with deductions.
- Reduce your risk of mistakes: If you’re doing your taxes on your own, it’s incredibly easy to make a mistake. Although a small mistake doesn’t seem like a big deal to you, it can trigger an IRS audit and result in costly mess. A tax pro can help ensure that your taxes are completed properly so you’re less likely to get audited.
- Reviews of past returns: If you missed out on deductions or tax credits on past returns, a tax pro can help you amend them so you receive any owed refund money.
- Money-saving tax planning: Not only can a tax professional help you in the immediate time frame, but they can also help you better plan for your future taxes.
- Avoid costly penalties: The IRS can garnish your wages and you can pay penalties for making mistakes on your taxes. When you consult a tax professional, you can come to a more reasonable compromise like installment payments you can actually afford.
- Peace-of-mind: If you’re worried or anxious about your taxes, you can feel more relaxed knowing your taxes were prepped and completed by a knowledgeable professional.
- Resolve questions: When you work with a professional, you get the opportunity to ask questions as it relates to your finances. If you call the IRS, especially during tax season, you’ll be on hold for hours.
- Saves you money: Tax professionals know the ins and outs of the tax code. Thanks to their in-depth knowledge, they can more easily find tax credits and tax deductions that can apply to your tax return.