If you’re in charge of coordinating and filing taxes for your business, deferred tax liabilities are one tax and accounting complexity that should definitely be on your radar. Wondering what deferred taxes are or why they matter to your business? We’re here to help.
In this post, we’re going to answer the following questions:
- What is deferred tax liability?
- Why does deferred tax liability matter?
- How do you calculate deferred tax liability?
- How does deferred tax liability impact your taxes?
Looking for quick answers regarding deferred tax liabilities for your business? Use the links below to skip ahead, or read end-to-end for a complete perspective on deferred tax liabilities.
Deferred tax liability definition
Deferred tax liability (DTL) is when a tax is owed by a company but has not yet been paid. This discrepancy happens mainly because of the difference in how business accounting and taxes are structured. If your business uses the accrual-based accounting method, as most businesses do, you may have some revenue that’s billed in one tax year, but not actually earned until the next.
The IRS handles this situation by allowing businesses to defer their tax liabilities to the tax year in which the revenue is realized.
There are a few reasons a business might have deferred tax liabilities:
- When an installment sale is made, so sales revenue has been billed, but not earned in the same tax year.
- Similar to installment sales, credit sales can also impact when revenue is actually earned.
- Your assets depreciate, so there is a difference between your accounting income and taxable income.
Of course, your business will have to remit these tax dues to the IRS in order to comply with the business tax rate that’s required of you based on your net income. To help your business keep track of this future expense, it should be included within the liabilities column of your balance sheet.
Difference between deferred tax liability (DTL) and deferred tax assets (DTA)
While you were Googling “what is a deferred tax liability,” you likely encountered something called a deferred tax asset. These two terms are essentially the polar opposite of one another. While deferred tax liabilities are taxes a business owes to the IRS, deferred tax assets are taxes the IRS owes to the business. This can happen if a business has overpaid its taxes. In this case, a deferred tax asset would be considered just that, an asset, because it’s money coming into the business as revenue.
There you have it, that’s what a deferred tax liability is in the simplest sense. But as most business matters go, there’s always more to learn and optimize. Keep reading to expand your knowledge on deferred tax liabilities and how they impact your business’s financial status, taxes, and potential for growth.
Why does deferred tax liability matter?
As we mentioned previously, deferred tax liabilities are important to account for because they impact your business’s taxes and financial status, and they can even impact your business’ growth—but how exactly does that all play out? Let’s take a deeper look at why DTL matters to each facet of your business’s financial picture.
How DTL impacts taxes
How DTL impacts taxes is as simple as this: if you have a balance due on tax payments, your business will have to make it up in the next calendar year. The only variable that should really impact this is whether or not the tax rates change, in which case, your balance could fluctuate so you may owe more or less in taxes than you initially expected.
How DTL impacts the financial status of your business
Whether you’re running a small business or large corporation, the best business owners and accountants know you’ve got to consider how every expense and avenue of income affects your finances and business operations as a whole. What this means for many companies is meticulously calculating your revenue and expenses to see how they impact your overall financial standing.
Since deferred tax liabilities are essentially tax debt that you’ll have to pay for in the future, you’ll want to plan for this expense so that you can make sure your books are balanced and primed for growth, not bankruptcy.
If you use the accrual basis of accounting, you’re in luck, because deferred tax liabilities can be easily accounted for using this method. Not sure if you use accrual or cash accounting? Let’s quickly define cash and accrual accounting.
Accrual accounting is an accounting style that functions on the idea that revenue and expenses are billed and earned and billed and remitted. Cash accounting on the other hand only recognizes revenue and expenses as they enter and exit the account. Most businesses prefer to use the accrual method, according to GAAP standards. To better understand how DTL impacts your business, let’s take a look at an example.
So, let’s say your business used the accrual method of accounting. If you have deferred tax liabilities to consider, what do you do with this information? To help you “account for” these expenses if you will, you’ll want to include the amount of taxes you owe under the “liabilities” section of your balance sheet. This way, you know what to expect when you’re trying to figure out how much money your business is making in comparison to how much it owes in taxes and other expenses such as operational fees, inventory costs, etc.
When these liabilities are combined with your business’ assets (real estate property, investments, inventory), you get your net worth. All of the information that comes from your balance sheet helps paint a broader picture of how much money is coming in, how much money you owe, and ultimately, where your finances stand. With this information at your disposal, you can optimize your finances and even watch your business grow…which brings us to “how does DTL impact business growth?”
How DTL impacts business growth
If your company stock is traded on the public stock market, your net worth is considered public information. Why? Many investors use this information to evaluate whether or not they want to invest in an organization. If a company appears to have way too much debt for the size of its revenue, this could be considered a red flag and may jeopardize the company’s ability to acquire future investments.
On the other hand, some large corporations use deferred tax liabilities to their advantage on the stock market since the company’s net worth is reflected as a lower number than what they’ve already accounted for. This could put them in a better position when it comes to offering dividends to shareholders and wages to employees—the higher the net worth appears, the more money they’ll ask for, which means less discretionary income for the business.
Keep in mind, DTL isn’t a bad thing and it doesn’t mean you underpaid your taxes…it’s just something you should consider when managing your business’ finances. If you anticipate that you’ll owe some deferred taxes later on down the line, you might want to work on paying down other sources of debt to help balance out your assets and liabilities.
Why would I have a deferred tax liability balance?
As we discussed before, deferred tax liabilities happen because of the differences in how tax code and business accounting practices are structured. To give you a better understanding of what this looks like, let’s take a look at a few hypothetical examples that are based on common reasons a business might have a deferred tax liability.
Example 1: Installment sales
Let’s say you run a business that offers TV streaming services to your clients. Each month, your clients pay a certain amount of money as part of their subscription—we’ll say it’s $10 a month for a minimum of 12 months. According to standard accounting rules, you can report this income as $120 you’ve earned for the year. As for tax code though, you’ll have to report/recognize this income as the installment payments are made each month.
For the months that won’t fall into the same tax year, you can count these tax dues in as part of your deferred tax liability, because you know that you’ll have to pay these tax dues eventually.
Example 2: Asset depreciation
One tax advantage the IRS offers businesses is the ability to write off the depreciation of its assets. In other words, when a company owns an asset like a fleet of vehicles or a piece of equipment, for example, the IRS would allow them to deduct a certain percentage of the money they “lost” as the asset became less valuable with age and use. Of course, the IRS has standards on how much a business can claim for depreciated assets, but that’s a story for another blog post. For more information, read our post on depreciable assets.
In addition to taxes, depreciable assets are also factored into accounting equations. But again, the IRS and accounting standards differ in how they cover this topic. As it applies to accounting, depreciation is generally calculated using a straight-line method, while the US tax code uses the accelerated depreciation method. Let’s take a look at another example to learn more.
For this example, we’ll say your company bought a car to make deliveries, pick up inventory, and run errands for general business purposes. Each year the car depreciates in value. When your accountant records the depreciation of this asset, they tell you that it will mean you subtract $5,000 from your accounting income this year. But when your taxes are filed during the same year, the depreciation is equal to -$8,000 in taxable income. This means that your accounting income is higher than your taxable income, and therefore, you’ll have to pay the remainder in taxes at a later date.
Example #3: Credit sales
Remember the installment sales example we gave before? Credit sales work in a similar sense because money is billed but sometimes not earned right away. Thanks to US tax code structure, your business can remit the taxes you owe on this revenue at a later time.
Is there a benefit to deferred tax liabilities?
According to Forbes.com, some corporations have used deferred tax liabilities to help them actually save money on taxes. This is not to say your company should necessarily try this strategy, but it’s important to note how deferred tax liabilities are (sometimes) used in the corporate world.
When the corporate tax rate was lowered from 35% to 21% in 2018, Forbes projected that corporations with large DTLs would benefit from this change because they’ll end up paying the lower rate for the taxes that they owe.
How to calculate deferred tax liability
If you want to figure out if you need to account for DTL, you’ll have to start by calculating deferred tax liabilities. The equation to calculate your deferred tax liability is:
DTL = Income Tax Expense – Taxes Payable + Deferred Tax Assets
To calculate your income tax expense, use this formula:
Income Tax Expense = Taxes Payable + DTL – DTA
Note: When calculating deferred tax liabilities (and assets) for your business, you should verify the current tax and depreciation rates that apply to your business. If the tax rate were to increase, for example, your DTL would reflect that, so you might have to budget more money in the future to account for an increase in liabilities. When you take these factors into consideration, you’ll be able to account for all of your expenses and assets more accurately.
If tax rates and crunching numbers isn’t your forte, hiring a professional accountant is your best bet. As an entrepreneur, you know that accounting for each and every dime that goes in and out of your business is essential. And accounting for the tax dollars that are incoming and outgoing is a huge part of that financial picture. A professional bookkeeping and accounting team can not only help you keep tabs on changing tax rates, but they can also create insightful reports that reflect your business’ financial wellness as a whole, including tax debt and revenue.
Where do I find deferred tax liability?
Your DTL should reside on the liabilities side of your books on your balance sheet. In addition to your deferred tax liabilities, this section should also include any other long-term debt obligations your business might have, including loans from shareholders, credit cards, etc.
Does having a deferred tax liability mean I was delinquent in filing and paying my taxes?
No, having a DTL does not mean that a company was delinquent in filing or paying their taxes. The IRS allows companies to defer their taxes to be paid at a later date. However, if you do not follow proper accounting and tax filing methods for your business, you could end up in tax trouble.
Hiring an accounting and business tax professional is an easy way to ensure your business is complying with state and federal tax rules. Failing to comply with these rules could end up in serious tax balances and even criminal charges, so it’s best to stay on the right side of the law when dealing with the IRS.
When do I pay deferred tax liabilities?
Businesses with deferred tax liabilities should make up their tax dues within the next calendar year. Unfortunately, the cycle doesn’t stop due to the structural differences in accounting and taxes, so you may find that your business will continue to have a balance for taxes owed year after year. If you’re on top of your accounting processes though, this shouldn’t pose any problems to your business, so long as you have a plan for paying back Uncle Sam.
Deferred tax liabilities, also known as “DTL” are taxes that businesses owe to the IRS. DTLs can happen for a number of reasons—depreciation, installment sales, credit transactions—but ultimately, it happens because of the difference in how accounting standards and US tax code is structured. When a business has DTL, they should be included in the liabilities section of their balance sheet so that the expense is accounted for and expected.
Above all, anytime you’re dealing with the IRS, it’s important to know that compliance is key. Want to learn more about business accounting and taxes? The team at Community Tax is here to help.