Taxation

Taxable Income

Types of Income Calculations

The terms revenue, income, and profit have distinct meanings within the accounting profession; calculating these figures is the basis for determining taxable income.

Income taxes are calculated based on income. There are a variety of types of income; therefore, the accounting profession uses a variety of synonyms for the term income. The terms revenue, profit, and income are often used interchangeably by laypeople, but tax accountants see these as very different quantities. When a business earns money from sales, this money is entered as revenue, or net sales or total receipts. Profit is the amount left over from total receipts or revenue once total cost (however defined) is subtracted. Some calculations include gross profit, sales minus the cost of goods sold, or gross margin, the total amount received from gross profit divided by sales.

From gross profit, other expenses are subtracted, such as all the expenses that are not direct business costs. Expenses include operating expenses to cover fixed and overhead costs and may include costs for financing and investments. If the expenses, except for interest expenses and taxes are used, the calculation results in the earnings before interest and taxes (EBIT), or the profit associated with operations. The EBIT is considered an important calculation for investors and business managers.

Gross profit minus expenses results in the net income before taxes. Net income is the receipts remaining after all expenses have been deducted. For many businesses, this is also the taxable income, or revenue minus deductible expenses, which is the amount on which the tax liability will be calculated. In its simplest form, the tax liability is calculated based on net income before taxes. Subtracting the tax liability from the taxable net income produces a net profit, or earnings after taxes. This figure is also popularly called profit or the bottom line.

Suppose that Industry Corp. is a manufacturing company with revenue of $10,000. When creating its income statement, its revenue is listed first. Next, Industry Corp. lists cost of goods sold, the costs directly associated with manufacturing, which is $275. Then gross profit, the amount available to pay for fixed and overhead costs, is $9,725. Next listed will be net income before taxes, which is calculated after listing operating income of $4,225 and then subtracting all other expenses or adding any other non-operating income. Net income before taxes for Industry Corp. is $4,231. Next, tax expense is listed and is used to calculate the final line, net income, by subtracting it from net income before taxes.

Net Income Calculations from Income Statement

Income calculations begin with revenue or total receipts, and income is broken down into net income before and after taxes.
The U.S. generally accepted accounting principles (GAAP) and Internal Revenue Service (IRS) do not share the same rules with respect to calculating taxes. Because of this, it is erroneous to say that the net income before taxes, calculated according to GAAP, is the same as the actual taxable income on the tax return. Suppose that a company had sales of $100,000 and made a $10,000 contribution to a political party. While the $10,000 payment is an expense on the income statement, it is not deductible on the tax return. Therefore, the GAAP financial statements would show net income of $90,000, but the tax return would show taxable income of $100,000.

Calculating Tax Base

The tax base will define how much money a company will need to pay, and it is linked to the information found on the income statement.

The tax base is the total income and assets on which the tax rate will be applied to determine the tax liability. A company's tax liability is the tax base times the tax rate. In the income tax context, taxable income is the tax base. In the United States, at the federal level, the Internal Revenue Service (IRS) is the taxing authority. Not all of the taxes levied are income taxes. The IRS is also responsible for many other types of taxes, such as gift taxes, estate taxes, and excise taxes. All of these tax forms require the calculation of the tax base. For a corporation, the form is 1120. There are varied tax rates that are levied against taxable income and the tax base for the various types of taxes. It is imperative that companies apply the correct IRS tax rate from these various tax categories to ensure that all tax liabilities are captured. This can be done by conducting research within IRS guidelines and laws.

As an example for income tax rates, the most straightforward way to calculate effective tax rates is to divide the income tax expenses by the earnings (or income earned) before taxes. If a company earned $250,000 and paid $50,000 in taxes, the effective tax rate can be calculated by dividing the taxes by the company earnings. In this situation the tax rate is calculated to be 20 percent.
$50,000$250,000=0.20or20%\frac{\$50{,}000}{\$250{,}000}=\;0.20\;{\text{or}}\;20\%
Focusing solely on income, the tax base is calculated starting with gross receipts. From the gross receipts, any allowances or returns are deducted. Cost of goods sold is subtracted and results in the gross profit. Atypical income, or income that is not expected from year to year, is added to this figure. Some examples of atypical income are interest earned, rent, and royalties. The result is total income.

Next, after the income, tax deductions are listed. A tax deduction is a reduction to taxable income, which in turn reduces the tax base. Tax deductions include expenses broken down into approximately a dozen inclusive categories. The total income minus the total deductions results in the taxable income, which is the tax base.

Financial statements and IRS tax returns are related, but it is important to understand when they differ and when they do not. Depreciation is one notable example. Depreciation is the process of allocating the cost of a fixed asset to an expense account over the life of the asset. Suppose that a company purchases a computer system for $100,000. Suppose further that, under generally accepted accounting principles (GAAP), the computer system must be depreciated straight line over 10 years, which yields a depreciation expense of $10,000 per year for 10 years. Suppose, on the other hand, that tax laws in effect at the time the computer system was purchased permit the company to depreciate the asset over 5 years instead of 10. This will lead to a depreciation deduction on the tax return of $20,000. In year 1, the company will have a $10,000 depreciation expense on the income statement but a $20,000 depreciation deduction on the tax return.

Calculating a Corporate Tax Base

For corporations, the IRS requires reporting on Form 1120. The first entry is gross receipts or sales; then all deductions are listed. The result is the tax base, or the total income and assets on which a tax rate will be applied to create a tax liability.

Taxable and Nontaxable Income

Tax structure, residency status, and depreciation all determine what income is taxable; therefore, differences exist between tax returns and financial statements.

An income statement shows all income, whether it is taxable or not. Tax returns, on the other hand, only show taxable income. Whether income is taxable or not depends on tax laws in effect when the income was earned.

Tax laws determine whether income is taxable or not and can exempt income from income tax for various reasons. For example, interest earned from investments in municipal bonds is not taxable, whereas interest earned from investments in corporate bonds is taxable. This will cause taxable income to be lower than financial statement income.

The tax base from taxable income can be lowered by depreciating the value of an asset. Depreciation is the process of allocating the cost of a fixed asset to an expense account over the life of the asset. Suppose that Industry Corp. is depreciating a piece of equipment. Ignoring the reasons, suppose further that generally accepted accounting principles (GAAP) depreciation on the income statement is $10,000 while depreciation on the tax return is $20,000. Since this asset is being depreciated faster on the tax return than on the income statement, this will yield a lower taxable income than the income on the financial statements.

Calculating Depreciation

U.S. GAAP and the IRS allow different depreciation calculations; the resulting tax varies depending on the situation, which can create a tax liability.
Suppose that, before depreciation, Industry Corp. had income of $110,000 on both the income statement and tax return. Suppose further that the company is subject to a 25 percent flat tax rate. On the income statement the company will have a $100,000 net income and a $25,000 tax expense. On the tax return it will have a $90,000 taxable income and a $22,500 tax liability. The faster depreciation on the tax return saved the company $2,500. This discrepancy in depreciation will eventually reverse when, in coming years, the asset will be depreciated more on the income statement than on the tax return. Therefore, the $2,500 saving is a temporary book-tax difference called a deferred tax liability. A deferred tax liability is a debt created as a result of the difference between financial statement income and taxable income. This means that, at some point in the future, the tax expense on the income statement will be higher than the tax due on the tax return.