Pay Me Now or Pay Me Later: Deferred Taxes

There's a challenge when you move from posting your accounting transactions to filing a tax return. Actually, there are two problems:

#1 Permanent Differences: There are transactions in your accounting records that never appear on your tax return. The reverse is also true. Certain amounts on your tax return are never posted to your books (accounting records). As a result, the income tax liability you post to your books will never agree with the liability of the tax return. Accountants call these transactions permanent differences.

#2 Temporary Differences: These differences are a matter of timing. The tax liability you post to your books is different from the amount on the tax return. However, this difference is temporary. Eventually, the total tax liability for your books and your tax return will agree in total. For example, years 1 and 2 may be different, but by year 5, the tax liability for all 5 years (the total) is the same- the book tax liability equals the liability of the tax return.

Using the word "deferred": The word deferred means to put off something. The temporary differences may mean that you owe more taxes later- because your future taxable income is higher. Accountants call that a deferred tax liability. If you owe less tax later (because of lower income in the future), you have incurred a deferred tax asset.

The zero sum game- Temporary differences: Over the long term, the total tax liability for your books and your tax return will agree in total. A deferred tax liability of $100 (more tax later) will be offset by a deferred tax asset (less tax later). If you only had one temporary difference, the deferred tax liability would equal the deferred tax asset- the two amounts would cancel each other out.

You'll see an example of a temporary difference in Part 2 of Deferred Taxes. In the meantime, this video might help:

http://www.youtube.com/watch?v=8FrOhg2PLpQ

Your comments are welcome! For live chats on some of the toughest accounting topics, go to my website listed below.

Thanks!

Ken Boyd

St. Louis Test Preparation

(cell) (314) 913-6529

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Author/ Cost Accounting for Dummies (John Wiley and Sons) March 2013