What Are Deferred Tax Liabilities & How Are They Calculated?

A deferred tax liability represents a future tax payment a company is obligated to make to the government. It arises from a mismatch between the rules for reporting financial results to investors and the rules for calculating taxes owed to the Internal Revenue Service (IRS). For a given reporting period, a company might report a certain amount of income on its financial statements but report a lower amount to tax authorities. This timing difference means the company pays less tax today, and the unpaid portion is recorded as a liability acknowledging the payment will come due in a future period.

The Origin of Deferred Taxes

Deferred taxes are a consequence of businesses navigating two different sets of accounting principles. For financial reporting, public companies in the United States must adhere to Generally Accepted Accounting Principles (GAAP) to provide a consistent picture of their financial health. Separately, when filing taxes, companies must follow the Internal Revenue Code (IRC).

This dual-reporting requirement leads to “temporary differences,” which are revenue or expense items recorded in one period for book purposes but in a different period for tax purposes. The difference is purely about timing; eventually, the total amount of income or expense recognized under both systems will be the same.

These are distinct from “permanent differences,” which do not create deferred taxes. A permanent difference occurs when an item is recognized for book purposes but is never for tax purposes. For example, interest income from a tax-exempt municipal bond is recorded as revenue but is not taxed, creating a permanent gap that does not result in a deferred tax liability.

Common Causes of Deferred Tax Liabilities

One of the most frequent sources of deferred tax liabilities is the treatment of depreciation expense. For their financial statements prepared under GAAP, companies often use the straight-line method of depreciation, which spreads the cost of an asset evenly over its useful life. For tax purposes, however, companies use an accelerated depreciation method, such as the Modified Accelerated Cost Recovery System (MACRS), which allows for larger depreciation deductions in the early years of an asset’s life. This larger initial expense reduces the company’s current taxable income, thereby lowering its immediate tax bill and creating a temporary difference.

Consider a company that buys a machine for $100,000 with a five-year useful life. Using straight-line depreciation for its books, it records $20,000 in depreciation expense each year. Under MACRS for tax purposes, it might be able to claim a $33,330 depreciation deduction in the first year. The book-tax difference is $13,330. The deferred tax liability is created to account for the future tax that will be paid when tax depreciation falls below book depreciation in later years.

Installment sales provide another example. When a company sells a product on an installment basis, GAAP requires that all the revenue from the sale be recognized in the period the sale occurred. The tax code, however, often permits the company to recognize the income for tax purposes as it receives cash payments from the customer over several years. This mismatch creates a deferred tax liability for the taxes owed on the yet-to-be-received cash.

Unrealized gains on certain types of investments also contribute to deferred tax liabilities. Under GAAP, investments held for trading must be adjusted to their fair market value at the end of each reporting period. Any increase in value is recorded as an unrealized gain in the company’s book income. For tax purposes, this gain is not recognized or taxed until the investment is actually sold, creating a deferred tax liability.

Calculating Deferred Tax Liabilities

The calculation of a deferred tax liability involves multiplying the cumulative temporary difference by the applicable enacted future tax rate. This calculation determines the amount of tax that is being postponed to a future period.

To execute the calculation, a company first totals all its temporary differences that will result in higher taxable income in the future. Using the earlier depreciation example, the temporary difference in year one was $13,330. To find the deferred tax liability, this amount is multiplied by the tax rate expected to be in effect when this difference reverses. If the enacted corporate tax rate is 21%, the deferred tax liability recorded at the end of the first year would be $2,799.30 ($13,330 x 0.21).

A key element in this formula is the use of the “enacted tax rate.” This means companies must use the tax rate that has been officially passed into law for the future years when the temporary differences are expected to reverse. Companies cannot use anticipated or proposed tax rates. If the government enacts a change in tax rates, companies must adjust their deferred tax liability balance in the period the new law is passed, resulting in a one-time charge to its income tax expense.

Financial Statement Presentation and Reversal

Once calculated, the deferred tax liability is recorded on a company’s balance sheet. It is most often classified as a non-current liability because the underlying temporary differences, such as those from depreciation on long-lived assets, typically take more than one year to reverse.

The deferred tax liability also has an effect on the income statement. A company’s total income tax expense reported on this statement is composed of two parts: the current tax expense, which is the amount payable to the IRS for the current year, and the deferred tax expense. The deferred tax expense is the change in the deferred tax liability balance from the beginning to the end of the period.

A deferred tax liability is not a permanent debt; it is a timing difference that resolves itself over an asset’s life or a contract’s term. This is known as a reversal. For example, in the later years of an asset’s life, its accelerated tax depreciation under MACRS will become smaller than its straight-line book depreciation.

When this happens, the company’s taxable income will be higher than its book income, and it will pay more tax. As it pays this higher tax, the deferred tax liability that was established in the early years is drawn down, or “reverses,” until it eventually reaches zero when the asset is fully depreciated.