As a small business owner thinking about taxes, it’s easy to get lost in the terminology and complex rules.
However, understanding the terms and applying them correctly can really affect your business’ bottom line. If the terms “deferred tax assets” and “deferred tax liabilities” have you confused, today’s post will provide simple definitions and explain how these concepts apply to small business taxes.
What are deferred tax assets and deferred tax liabilities?
Deferred tax assets and liabilities are both caused by temporary differences between your business’ book tax and actual income tax. Let’s start by defining these terms:
- Deferred Tax Asset (DTA): This is an amount of taxes that a business has overpaid or deferred and expects to recover in the future. In other words, a DTA is a future tax benefit. This happens if your business paid too much in taxes or incurred losses that you can carry forward to offset future tax bills. DTAs never expire, so you can determine when your business would most benefit from using your DTA.
- Deferred Tax Liability (DTL): This amount represents taxes that a business will owe in the future. This is usually due to a difference between your accounting income (how you report your earnings) and your taxable income (how the IRS calculates your earnings). Basically, it’s tax money you’ll owe later because your business’ accounting methods aren’t the same as those of the IRS. Simply put, those differences have to do with the timing of when a company reports income for accounting purposes rather than for tax purposes.
What are some examples of deferred tax assets and deferred tax liabilities in small businesses?
I think the best way to explain these concepts is to provide examples. Let’s start with two examples of DTA:
- If your business had a $10,000 loss with a tax rate of 20%, that loss would result in a $2,000 DTA. This means that your business will likely receive a tax refund or your tax bill will be reduced by $2,000 in future tax years when your business is profitable.
- If you prepaid certain expenses such as insurance or rent, the IRS allows you to deduct the full amount in the current tax year even though your business may only incur the expense over several months or years. The IRS recognizes the expense faster than your business does for accounting purposes, so this creates a temporary difference that leads to a DTA.
As for DTL, here’s a common example of how this looks in the real world:
- If your business buys equipment and uses accelerated depreciation for tax purposes, you’ll deduct the cost of the equipment more quickly than you would for accounting purposes. For example, if the equipment costs $5,000 and the depreciation is higher during the first year, this means you’ll pay less in taxes during the current tax year. However, in future tax years, your business will have higher taxable income because the depreciation deduction won’t be available anymore. The result is a DTL since the tax savings you received in the first year will be “paid back” over time.
How do deferred tax assets and deferred tax liabilities affect small businesses?
While these terms might sound technical, here’s how they can be relevant to small business owners when it comes to financial planning and tax strategy:
1. Cash Flow
Deferred tax assets and liabilities directly affect your business’ cash flow. If you have a solid understanding of what tax benefits and liabilities you’ll be getting or paying and when that money will come in or out, then you can plan your business’ cash flow more effectively and accurately, which means you won’t find yourself in a pickle down the road.
2. Decision-Making
Small business owners quickly find out that almost all of our decisions are directly tied to our finances, so making choices that result in deferred tax assets or liabilities should just become a natural part of developing as a business owner who looks at the big picture.
For instance, if you’re considering an investment in equipment or property, you need to take the time to consider the tax implications of those choices. If you choose to accelerate depreciation on that equipment or property, that will provide short-term tax relief, but it could create a future tax liability.
3. Avoiding Tax Audits
When it comes time to file your taxes, if your business has significant deferred tax assets or liabilities, the IRS may scrutinize your tax filings more closely. However, if you understand how these accounting-related timing differences work, and you can explain them accurately to your accountant, you can make sure that your filings are accurate and compliant with tax laws so that even if you do get audited, you’ll have nothing to worry about.
Final Thoughts
By understanding how accounting timing differences can create DTAs and DTLs, you can make more informed decisions about your finances, plan for your future tax obligations, and ensure that your business is financially healthy. The best way to track these deferrals is by consulting with an accountant who can help you determine the best way to strategically manage your taxes and cash flow.
