What Is Tax Liability?

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If you earn income from a job, business or investments, there’s a good chance you have tax liability. The amount of the liability depends on your taxable income.

Check Out: What To Do If You Owe Back Taxes to the IRS

It’s critical for all taxpayers to understand what a tax liability is and how it affects one’s overall finances.

What Is Tax Liability?

Tax liability is the total amount of tax debt a business entity or an individual owes to a local, state or federal taxing authority.

What Counts Toward Your Tax Liability?

As they apply to individuals, tax liabilities result from taxable income, which can come from a variety of sources. For example:

• Wages and benefits you earn as an employee
• Income you earn from self-employment, including side jobs
• Capital gains from the sale of capital assets — assets you purchase for personal or investment purposes
• Investment income from dividends, interest and stock splits or trades
• Distributions from retirement plans, pensions and annuities
• Unemployment benefits
• Social Security benefits
• Canceled debt
• Gambling winnings

Tax liability also applies to business income. In addition, if you own a retail establishment or another type of store, tax liability can occur from collecting sales tax on products sold.

If you have employees, your share of their payroll taxes, which encompasses Social Security and Medicare taxes, is also a tax liability.

How To Reduce Your Tax Liability

You can reduce your tax liability by reducing your taxable income.

Adjustments to Income

Adjustments to income are technically tax write-offs that reduce your tax liability, but you are not required to itemize them. When making adjustments to income, you subtract certain expenses, fees, contributions and payments directly from your total income, which will give you an adjusted gross income. For example, you can deduct up to $300 of educator expenses and up to $2,500 of student loan interest you paid during the tax year. You can find other options for adjustments to income on Schedule 1 of Form 1040.

Tax Deductions

Other ways to help reduce tax liability include taking full advantage of deductions for contributions of pretax dollars to retirement accounts, participating in flexible spending accounts and deducting the expenses related to making charitable contributions.

It is important to note that to take maximum advantage of most of these potential tax breaks, you must itemize your deductions on your tax returns. But keep these things in mind:

• It only makes sense to do so if itemized deductions exceed the standard deduction you are allowed.
• Keep track of deductible home office and auto expenses, salary and benefits paid to employed family members and carry-over tax deductions from prior tax years. These items are valuable ways to reduce tax liability.
• It’s also always an excellent idea to seek out and use any available free tax help resources.

Tax Credits

A tax credit is a dollar-for-dollar reduction in your tax liability. Common credits include the earned income tax credit, the child tax credit and the child and dependent care credit. However, the IRS also provides credits to help taxpayers save and invest, pay higher education expenses, purchase an electric vehicle and pay for health insurance, to name a few.

Professional Tax Help

Both individuals and entrepreneurs can reduce tax liability by seeking professional tax help for their accounting and tax preparation needs. A professional can ensure that you claim every adjustment, deduction and credit you qualify for, and that your returns are prepared and filed correctly and on time, which can help you avoid penalties and fees.

How To Determine Your Tax Liability

Your Form 1040 — or the tax software you use in place of a paper form — will walk you through listing your income, adjustments, deductions and credits. Once you’ve added up your income and subtracted adjustments, deductions and credits, you’ll use an IRS tax table to determine your tax liability. Then adjust that amount to account for payments you’ve already made, such as through payroll withholding or estimated tax payments, to calculate how much you have to pay — or have refunded.

Cynthia Measom contributed to the reporting for this article.

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