Tax liability is the total amount of tax debt owed by an individual or corporation to a tax authority. Whether you file business taxes, individual taxes or both, you’re probably subject to tax liability. It’s critical for all taxpayers to understand not only what tax liability is, but 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. If the tax withholdings or payments made on your behalf are less than your tax liability, you owe the difference and must pay it before the tax deadline.
As they apply to individuals, tax liabilities are incurred on activity such as earned income, a gain on the sale of an asset, an early distribution penalty for retirement accounts or a supplemental tax for failing to purchase adequate health insurance coverage under the Affordable Care Act.
What Counts Toward Your Tax Liability?
Besides owing taxes as an individual on taxable things like earned income and asset sales, tax liability also applies to income a small-business owner might incur while running their company. In addition, if you own a retail establishment or another type of store, tax liability can occur from collecting sales tax on products sold. The sales tax is computed by applying the tax rate to the total dollar amount of sales, and it must be submitted quarterly to local and state taxing authorities.
In addition to sales taxes, if you have employees, a significant tax liability accrues due to the employer’s share of employee payroll taxes, which encompass Social Security and Medicare taxes.
How Capital Gains Can Increase Tax Liability
Selling an asset like a piece of art, an investment or a parcel of real estate for more than it was purchased for creates what the IRS calls a taxable capital gain. For example, if a real estate investor buys a tract of land for $100,000 and sells it eight years later for $150,000, they’ve made a profit of $50,000, which would generally be taxable and thus add to their overall tax liability.
Capital gains tax rates differ depending on the amount of time the underlying property is held and the individual’s taxable income. Because capital gains can be quite large, they need to be anticipated and accounted for when thinking about future tax liability.
How To Reduce Your Tax Liability
Fortunately, individuals and businesses, both large and small, can take simple and concrete steps to reduce their burdensome tax liabilities. In some cases, the tax reduction steps are the same.
Professional Tax Help
One prominent example is the fact that both individuals and entrepreneurs can reduce tax liability by seeking professional tax help for their accounting and tax preparation needs. According to the IRS, tax experts such as certified public accountants and qualified tax advisors can be invaluable resources.
DIY Tax Software
Using high quality, up-to-date tax software designed to find every customer every available deduction can save you a bundle of money by pointing out tax breaks you might otherwise miss. Tax preparation giants H&R Block and Turbo Tax have excellent options that business owners and individual taxpayers should consider.Tax Credits
Tax credits reduce taxes dollar for dollar because they are subtracted from an individual’s or business’ tax liability. But not all tax credits are created equal. For example, the earned income tax credit for individuals is fully refundable, which means that if its value exceeds the taxpayer’s liability, the IRS will refund the excess. Other tax credits are nonrefundable, which means you’ll only get a refund up to the amount you owe.
Find Out: 3 Tax Credits Every Parent Should Know
Adjustments to Income
Adjustments to income are technically deductions 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 $250 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.
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.
Learn More: 9 Legal Tax Shelters To Protect Your Money
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 itemizing deductions will exceed the standard deduction you are allowed.
- Always 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 sometimes overlooked but are nonetheless valuable ways to reduce tax liability.
- It’s also always an excellent idea to seek out and use any available free tax help resources.
What Is Deferred Tax Liability?
Deferred tax liability is created when a business delays making scheduled tax payments. This can occur for a number of reasons, but usually deferred tax liability is created because the pretax income reflected on the company’s books at a given time is more than the actual taxable income that will be incurred. Many types of transactions can result in temporary differences between pretax book income and taxable income.
These special circumstances are always temporary. The situation tends to reverse itself, and the tax that was deferred will become due and payable.
How To Determine Your Tax Liability
As you calculate your taxes and complete your IRS Form 1040 for filing, all the various items that add to your tax liability are collected and documented. Once they are all added together, they are recorded on the very last page of your form 1040 on line No. 16. That’s how you come up with your gross tax liability.
Line 16 can be frightening, and the number might make you nervous when you first write it in. But don’t worry about the amount quite yet it still has to be adjusted for withholding, estimated tax payments, tax credits and a few other items. This is your net or final tax liability.
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Last updated: April 28, 2021