4.7 Income Taxes - 4.7 Income Taxes Explained

Key Concepts

• Taxable Income
• Tax Rates
• Deferred Tax Assets and Liabilities
• Tax Credits and Deductions
• Effective Tax Rate

Taxable Income

Taxable Income is the portion of a company's or individual's income that is subject to taxation. It is calculated by subtracting allowable deductions from gross income. Taxable income is the basis for determining the amount of tax liability.

Example: If a company has gross income of $1 million and allowable deductions of $200,000, its taxable income would be $800,000.

Tax Rates

Tax Rates are the percentages at which income is taxed. These rates can be progressive, meaning higher income is taxed at higher rates, or flat, meaning the same rate applies to all income levels. Tax rates are used to calculate the total tax liability.

Example: In a progressive tax system, if the first $50,000 of income is taxed at 10% and the next $50,000 at 20%, a taxable income of $100,000 would result in a tax liability of $15,000 (($50,000 * 10%) + ($50,000 * 20%)).

Deferred Tax Assets and Liabilities

Deferred Tax Assets and Liabilities arise when there is a difference between the tax basis and the accounting basis of an asset or liability. Deferred Tax Assets represent future tax savings, while Deferred Tax Liabilities represent future tax payments.

Example: If a company capitalizes an asset for accounting purposes but deducts it for tax purposes, it will have a Deferred Tax Liability because the tax deduction will occur in the future, increasing future tax payments.

Tax Credits and Deductions

Tax Credits and Deductions are mechanisms to reduce tax liability. Tax Credits directly reduce the amount of tax owed, while Tax Deductions reduce taxable income, thereby reducing the tax liability indirectly.

Example: A company might claim a $10,000 tax credit for research and development, which would reduce its tax liability by $10,000. Alternatively, a $10,000 tax deduction would reduce taxable income by $10,000, resulting in a lower tax liability based on the applicable tax rate.

Effective Tax Rate

The Effective Tax Rate is the average rate at which a company or individual is taxed. It is calculated by dividing the total tax liability by the taxable income. The Effective Tax Rate provides a clearer picture of the overall tax burden compared to the statutory tax rates.

Example: If a company's taxable income is $1 million and its total tax liability is $250,000, the Effective Tax Rate would be 25% ($250,000 / $1,000,000).