Buckle your seatbelts because we’re about to go on an income tax provision ride. In this blog, we will be primarily focusing on current versus deferred portions of an income tax provision. Let’s begin by defining some terms. A tax provision is the income tax corporate entities will incur based upon the company’s net income for the year. A deferred income tax liability results from a difference in income recognition between tax laws and the company’s accounting methods per GAAP. Within deferred tax liabilities are deferred tax assets (DTA) and deferred tax liabilities (DTL). You may have heard of temporary and permanent tax differences. Temporary differences are what drives DTAs and DTLs. Permanent differences are differences between financial accounting and tax accounting that will never be eliminated. An example of permanent differences are penalties and fines. These may be expensed on the company’s books; however, it must be excluded from tax, and it will never be recovered in future years. Some more examples of permanent differences are meals and entertainment (which may only be expensed 50% for tax), life insurance proceeds, municipal bond interest and more.
Temporary differences, on the other hand, are differences between pretax book income and taxable income that will reverse in the future or be eliminated. Essentially, the items that cause temporary differences are recognized in financial accounting and accounting for tax purposes, but at different times.
Let’s look at an example: In 2020, your tax rate (excluding state taxes) is 21%. Your company has revenue of $200,000 and fixed assets valued at $100,000 depreciating straight-line over five years. That means your company is depreciating $20,000 per year. However, tax laws allow you to fully depreciate the fixed assets all in year one. See below how this drives the differences between book versus tax net income.
|Tax Expense||($37,800) >||($21,000)|
Let’s pretend that in 2021, revenue remains constant to keep this simple. Remember that tax has fully depreciated assets in 2020, so there will be $0 depreciation expense in 2021.
|Tax Expense||($37,800) <||($42,000)|
You notice that fixed assets will continue to be depreciated by $20,000 for five years; whereas it was fully depreciated in the first year for tax. If we were to layout this example for all five years, you will notice that the differences reverse itself by the end of the life of the asset.
Now, how does this tie into deferred tax liabilities? In the example above, you will see that the combined tax expense per books is greater than tax expense per tax. The book tax expense is a function of book net income multiplied by the tax rate. As current year tax expense is $21,000, the total combined income tax provision of $37,800 is comprised of a $21,000 current tax provision and $16,800 deferred tax provision. The deferred tax provision will be recorded as an expense with a related increase in deferred tax liabilities.
The opposite occurs when you have a deferred tax asset, which is when tax expense per books is less than tax expense per tax. An example of when this can happen is when companies have bad debt. Say in year one, your company has increased its allowance for doubtful accounts but the receivable not been fully written off. Bad debt expense will only be expensed for tax purposes if it’s been written off. Therefore, in the first year, your company will have a higher expense on their books than reflected on the corporate income tax return, since it has not been written off. This creates a deferred tax asset. This will be reversed in the future year when the company writes off receivable, and it gets recognized as a tax deduction.
If you have any questions regarding this or other accounting issues, contact your Henry+Horne advisor.