What is a Tax Expense?
How Does a Tax Expense Work?
The formula for tax expense is:
Tax Expense = Effective Tax Rate x Taxable Income
For example, let's assume the Company XYZ has an effective tax rate of 35%. The company's taxable income (that is, income net of tax deductions and non-taxable items) is $1,000,000. According to the formula, Company XYZ's tax expense would be:
Tax Expense = $1,000,000 x 0.35 = $350,000
Of course, in the real world, calculating tax expense is far more complicated. Certain types of income are subject to certain levels of taxation. For example, employers must pay payroll taxes on wages, sales taxes on certain asset purchases and excise taxes on still other purchases, in addition to state and local taxes, both of which have their own rules for what income is taxable or not taxable.
Why Does a Tax Expense Matter?
Tax expense often has a large effect on a company's net earnings, because in some cases as much as 30%, 40%, or even 50% or more of a company's profits may go to various state, local, and federal governments. This can dramatically reduce the amount left for the shareholders, who may then pay taxes a second time if the company pays a dividend.
Alternatively, when companies do not have taxable income, they do not record a tax expense. In fact, they are usually allowed to carry their losses forward to offset or eliminate future taxes as well.
It is important to note that tax expense is not the same as tax liability. A tax liability is a balance sheet item that denotes the amount of tax that is expected to be paid in the future.