What Is Tax Liability?

Find out how tax liability affects you.

Whether you only pay taxes as an individual or you are also a contractor or business owner, tax liability often applies. It’s important to understand not only what tax liability is, but also how it affects your bottom line.

Read on to find out more about tax liability and ways you can reduce it.

What Is Tax Liability?

Tax liability is the total amount of tax you owe a local, state or federal taxing authority. If the tax withholdings or payments made on your behalf are less than your tax liability, you owe the difference. Tax liabilities for individuals apply to situations such as earned income, a gain on the sale of an asset, an early distribution penalty for retirement accounts or a lack of coverage under the Affordable Care Act.

What Counts Toward Your Tax Liability?

Besides owing taxes as an individual on things like earned income and asset sales, tax liability also applies to earned income if you are a small-business owner. In addition, if you own a store, tax liability can occur from collecting sales tax on products sold. The sales tax for each sale must be submitted to local and state taxing authorities.

Also, if you have employees, tax liability applies to the employer’s share of payroll taxes, which includes Social Security and Medicare taxes.

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How to Reduce Your Tax Liability

Both individuals and small-business owners can take steps to reduce tax liabilities — many times in the same way. For example, both individuals and entrepreneurs can reduce tax liability by seeking tax help, such as using tax software or hiring a CPA for income tax preparation. Both options can reduce the amount of missed income tax deductions or other errors.

Other ways individuals can reduce tax liability include contributing pre-tax dollars to retirement accounts, participating in flexible spending accounts and deducting expenses related to charitable contributions.

Note that you must itemize your deductions during tax filing to take advantage of these potential tax breaks. And it only makes sense to do so if itemizing deductions will exceed the standard deduction you are allowed for the year.

Additional ways business owners can potentially reduce tax liability include deducting home office and auto expenses, employing family members and tracking carryover tax deductions.

What Is Deferred Tax Liability?

A deferred tax liability is created when a business delays tax payments because the pre-tax income reflected in the company’s books is more than the actual taxable income. Many types of transactions can result in temporary differences between pre-tax book income and taxable income, according to the Corporate Finance Institute.

But this is only temporary. In the future, the situation will likely reverse, and the company will end up paying the tax that was deferred.

Understanding tax liability is essential. This knowledge will make you better equipped to reduce the amount of taxes you owe — which means you can keep more of your hard-earned money in your pocket.

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