A tax liability might sound very familiar, yet confusing. However, you should not get scared. Simply put, it is the amount of taxes you would need to pay to the IRS. It is the total debt you owe to the IRS. The keyword here is total. What it means is that this is the amount that you need to pay on all the income sources (less deductions and other write-offs) for the year.
Besides the federal tax liability, you might come across sales tax liability or state or local tax liability. No matter what type of tax it is, when you see the word liability it means that you owe something. So, your business can owe some taxes on sales it had or your state or county might have you pay more taxes besides the federal taxes.
Tax Due
Tax liability is often mixed up with a similar term – tax due. Although both deal with the taxes, the tax due can be explained as the amount of tax liability that is left over to pay. As an individual or a business, you actually pay your taxes every week or couple of months. If you are hired by another business, then that business owner is required by law to take a portion of the money you earn as a worker and send it to the IRS. When you fill out the form W-2, you ultimately tell your employer how much should be taken from your paycheck every time one is given to you.
In the end, it turns out that this money can completely cover your tax liability and if your W-2 was not completed perfectly, you might even have overpaid, so the government will return the portion you overpaid based on the information you provide in the tax return since it has all the data for tax liability calculation. Alternatively, you might still have a bit to pay, especially if you report some additional income outside of your employment. This amount that has yet to be paid is your tax due.
When it comes to businesses a similar concept is applied, with one exception. Businesses pay estimated taxes, which are similar to tax deductions on your paychecks but are paid only four times a year and are based on the estimated profit that the business will have for that year. Obviously, such estimations are just that – estimations, so the taxes a business pays do not equal their actual tax liability. Accordingly, the business might have a tax due. If it overpaid its taxes, it can record the overpayment on its Balance Sheet as an asset.
Calculation of taxable income
Before we start, we would like to draw a line between personal and business taxes. In a nutshell, for personal taxes, you would add all the money you received throughout the taxable year, which would be your W-2 job, 1099, unemployment, and so on. When filing taxes, you would enter your total income minus your deductions plus any tax credits. That would be your taxable income, which serves as the basis for calculating your tax liability. Taking into account how much you already paid throughout the year (which would be your paycheck tax deductions), you are going to get a refund or you are going to get a balance due.
On the business tax side, depending on what type of business structure that you have, you may need to do two separate tax returns:
- one for your business profits;
- one for the income that you earned as the business owner and any other personal income.
Sole proprietors and LLC owners do not have to file two separate returns because they can include business income and expenses on their personal returns using a form known as Schedule C.
You made, let’s say, $35,000 working your part-time job and you are doing your own little business on the side that brought you an income of $18,000. So, you would add the two together and that would be your taxable income. However, if you have a start-up and you invested $14,000, but only earned $6,000, then you actually had a loss of $8,000. So, you would report this on your personal tax return, saying that you invested $14,000 of your income into your company, but the profits were not able to cover the expenses, so you are reporting a loss. This loss would ultimately decrease your taxable income.
If you have other types of business, such as an S-Corp or C-Corp, you will have to file two separate returns. What does it mean for your tax liability? First, you would get a return for your business completed and pay any taxes on the profits it generated. Then, you would file your personal return, whether alone or with your spouse if you have one, where you would also include the amount of profit your company brought you, thereby increasing your taxable income.
Defining tax rates
Now when you know how to estimate your taxable income amount, you can start computing your tax liability. There is no complicated math because you simply need to go to the IRS website and find the tables with the tax rates corresponding to your filing status and the amount you earned. It is worth noting that although progressive taxation covers most income sources you would come across, it does not apply to all of them (e.g. long-term capital gain income).
The higher your income, the higher the tax rate you will pay on the portions of the income that surpasses certain levels. Essentially, your income is taxed in batches, with each following batch being taxed at a higher rate. However, when it comes to calculations, you only need to find the amount of taxes to be paid for the income that is over a certain level because the tax liability for everything below that is already given in the table.
