Net income provides a more accurate account of the financial status. Here’s why.
What is tax liability?
Tax liability is the total amount of tax owed in a given period, by individuals and organizations, to federal, state, and local governments. For businesses, tax liabilities are short-term liabilities recorded on a balance sheet and paid within a year. For individuals, tax liabilities are covered by withholdings from wages or salaries, or are paid out of pocket.
Individuals and organizations accrue tax liabilities with each taxable event, such as earning income, making sales, and issuing payroll. Each taxable event generates a specific amount of tax liability, calculated as a percentage of the total.
Earned wages and salaries generate tax liabilities. Employers withholding portions of wages and salaries to cover individual taxpayers’ liabilities. If the amount is less than a taxpayer’s total tax liability for the year, the unpaid difference must be paid by the individual; if it exceeds a taxpayer’s total tax liability, the difference is a tax refund.
Some taxpayers incur double taxation. When a business owner and her business are separate legal entities, the business’s income is taxed and the owner’s personal income is also taxed. Sole proprietorships, partnerships, and LLCs are not double-taxed.
Sales tax is another form of tax liability. When a business sells a product, most state and local governments charge sales tax as a percentage of the total sale. This amount is included in the total charged to customers. Businesses remit sales taxes to authorities on a monthly or quarterly basis.
Company payrolls incur tax liabilities. Businesses are required to withhold income taxes from their employees’ pay, as well as Social Security and Medicare taxes.
Individuals and businesses can reduce their total tax liabilities by claiming deductions, exemptions and tax credits. Many individuals claim standard deductions, although with enough personal and business expenses they can itemize deductions.
Check our our handy tax calculators and get a handle on what you owe Uncle Sam.
Tax liability example
Taxes on earned income are the most common type of tax liability. Franz earns $50,000 in gross income, reported on a W-2 form to the Internal Revenue Service (IRS). At a federal tax rate of 20 percent, the income tax liability of Franz’s salary is $10,000.
On his W-4 filing, Franz’s employer withheld $8,000 in federal taxes, and Franz made a $1,000 tax payment during the year. When he files his Form 1040 individual tax return, the remaining tax payment due is $1,000. Alternatively, if Franz’s employer only withheld $5,000 and he made no additional payments, Franz now owes the IRS $5,000.