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What Is Deferred Tax Liability?

Operating a business will require maintaining an accurate and up-to-date balance sheet that includes a wide variety of information. Some of the information commonly recorded on a balance sheet includes the assets, liabilities, and shareholder equity of a business at any specific point in time. 

A balance sheet can be a quick and easy way to determine a business’s overall health. It will provide the net worth and owner’s equity of your business if you were to sell all the business’s assets and pay off all the liabilities. The higher the net worth and potential equity for shareholders, the more likely investors will be interested in purchasing shares in the business. 

A business could use its balance sheet to influence its overall net worth in a few ways. One way is by using deferred tax liabilities. There are a lot of factors that will be in play when creating a deferred tax liability, and it can be difficult trying to accurately estimate the total deferred costs correctly. 

When trying to accurately estimate the total deferred costs a business would be wise to seek the perspective of an expert tax consultant to try to avoid any misrepresentation or miscalculation as to these deferred liabilities.

How Does Deferred Tax Liability Work?

When a business places a deferred tax liability on its balance sheet, this indicates that the business owes a future tax payment. Deferred tax liabilities are most commonly created to better match revenue with the expenses that generated the revenue. 

For example, a business that operates under an accrual-based accounting method defers the tax liability incurred during one fiscal year until the following fiscal year when the revenue is actually earned and collected by the business. The IRS permits the tax obligation to be deferred to the fiscal year in which the revenue is collected. 

Deferred tax liabilities are often created when installment sales are made, or purchases are made on credit. The business will create a bill of sale and exchange the product or render a service, but the tax payment won’t be due until the business receives the payment. 

Why Does Deferred Tax Liability Matter?

Using deferred tax liabilities is one way to persuade potential investors to buy shares and stocks of your business. One of the most important factors for investors of the stock market is a business’s overall net worth. 

The higher a business’s net worth, the more capital that is available for shareholder dividends and employee wages. Naturally, a business with a high net worth and low tax obligations would drum up more interest than one with a low net worth and high tax obligations. 

Deferred tax liability is one way to increase the overall net worth of your business, lower your taxes, and attract potential investors. It’s important to note that while the overall net worth value will be higher, the actual cash flow will be lower. 

You would still need to pay off these liabilities in the future, so it’s crucial that the money is set aside to pay the deferred tax when it comes due and is not spent on something else.  

How Do You Calculate Deferred Tax Liability?

The formula for calculating a deferred tax liability is the income tax expense minus taxes payable plus deferred tax assets. Look at an installment sale for a simple example of this formula.

Let’s say that a business sold a product for $1,800 that had a sales tax of 15%, and the customer will pay it off over 36 months. The customer would pay $600 each year (most likely in monthly installments), and the financial records for the business would indicate a sale of $1,800. 

However, the tax records would be different as they would only reflect $600 in payments each year. The deferred tax liability would be for each of these payments and would be $600 times the 15% sales tax for a total of $90. Therefore, the deferred tax liability would be $90 each year. 

Are There Risks With Deferred Tax Liabilities?

Although the example listed above was neat and straightforward, in most cases it can be a little bit tricky trying to figure out the exact amount of money that will be owed when your business has a deferred tax liability. This is often where a company can find itself in need of a professional accountant

Following are  a few examples of how a business could miscalculate the number of its deferred tax liabilities: 

Changing Tax Rates

A business could miscalculate the total tax liability if the business fails to factor in the current tax rate. 

The overall tax obligation owed will be calculated using the current tax rate for your business at the time the payment will be made, not the tax rate when the deferred liability was originally created. That means that if any tax rate has increased since the tax liability was created, you will owe a higher amount of tax when you finally make the tax payment. 

It’s not uncommon for sales taxes to change or for your business to reach a new threshold for tax withholdings. These differing rates can end up creating a much higher tax obligation than you may have been anticipating. 

However, it should be noted that the Tax Cuts and Jobs Act of 2017 made significant changes to the tax system. The maximum corporate tax rate was reduced from 35% to just 21%, and so deferred tax liabilities were greatly reduced in some cases. 

As a result of the Tax Cuts and Jobs Act of 2017, it should be much easier to calculate deferred tax liabilities using this new cap than it may have been in the past. 

Asset Depreciation

Another critical factor involved in calculating deferred tax liabilities is the concept of depreciation. 

The overall depreciation expense for long-term assets is normally calculated using a straight-line method. This means that the overall estimated deprecation of the asset will be split up evenly for every year that the asset is expected to be in use minus the salvage rate. 

For example, if a business needed new technology to manufacture a product, it would be labeled an asset despite costing money. Let’s say the total cost of the machine is $20,000, it’s expected to last for five years, and the salvage value at the end of its service period is $4,000. 

The sum of the total cost minus the salvage value would then be divided by the number of years. So $20,000 minus $4,000 would equal $16,000 which is then divided by five for a total depreciation value of $3,200 each year. The depreciation of this asset would then be multiplied by the tax rate of the business in order to determine the deferred tax liability. 

However, a business might not accurately predict these values, or a business could use an accelerated depreciation method. Using an accelerated method of depreciation will create a much larger disparity between overall earnings and taxable income. 

It might take years for the difference in depreciation methods to narrow, and the tax liability could end up being much different as a result. 

Inventory Valuations

There are essentially two types of inventory valuations available for a business: last-in-first-out (LIFO) and first-in-first-out (FIFO). 

When using LIFO, a business will record the most recently manufactured products as the first ones sold. This method is most commonly used by businesses with very large inventories and is used to take advantage of lower taxes when prices have been consistently rising. 

During these times of inflation, LIFO can help increase the overall net income valuation, which can be very beneficial for shareholders. The issue is that the deferred tax liability will be much higher and can often lead to higher than anticipated payments being owed. 

On the other hand, FIFO is a method where the oldest manufactured products are the first ones sold. This method is used to help reduce the depreciation of value in the inventory and can result in a more consistent valuation for inventory. 

The net income won’t be influenced very much during inflation, so the deferred tax liability will most likely be much closer to estimations. 

The Takeaway

Deferred tax liabilities are a complicated part of a business’s balance sheet. Deferred tax liabilities can be very beneficial when appealing to potential investors or paying taxes on sales where revenue hasn’t been collected yet. 

However, deferred tax liabilities can potentially lead to tax issues if not accurately calculated. Should taxes change during the process of collecting an installment sale, or if asset depreciation is incorrectly estimated, or valuations of inventory are judged poorly, then it could lead to much higher deferred tax liabilities coming due. 

Therefore it would be a good idea to consult with a tax professional from Coast One Tax Group. These certified accountants and lawyers might be able to help reduce your tax obligation to the IRS and make any necessary adjustments to the balance sheet of your business. 

Sources:

Balance Sheet Definition | Investopedia

Accrual-Based Accounting Explained: What It Is, Advantages & Examples | Netsuite.com

Topic No. 705 Installment Sales | Internal Revenue Service

Deferred Tax Liability/Asset | Corporate Finance Institute

Understanding Methods and Assumptions of Depreciation | Investopedia

How did the Tax Cuts and Jobs Act change business taxes? | Tax Policy Center

Why would a company use LIFO instead of FIFO? | AccountingCoach.com

First-in, first-out method (FIFO) definition | AccountingTools.com