Tax Planning: What Is Tax Liability

by Enid Kathambi, Finance Columnist


Published in Finance and Money on 30th January, 2020


Taxes are a hard topic to handle, not just in the classroom but also in real life. Once you become of legal age, there is no way to escape them. You are either preparing taxes for your business or yourself.

While there is the option of hiring an accountant to do your taxes for your tax planning purposes, it is ideal that you understand the basics.

Tax is quite broad, but today we will start with tax liabilities or obligations.

taxes

What is tax liability?

Tax liability is an amount one owes a taxing authority like the federal (IRS), state, or local government in a given period. Tax liabilities apply to both individuals and businesses.

For an individual, you can settle your tax liabilities from your pocket. One also settles their tax liabilities when a certain percentage of your wages or salary is withheld and remitted to the taxing authority by the employer. Businesses, on the other hand, record their tax liabilities in their balance sheet as a short-term liability. This means that the company has to pay the tax within a year.

Tax liabilities usually arise from taxable events. These are financial transactions that create a tax obligation or liability position like earning an income or a capital gain.

Types of tax liabilities

Payroll tax liability

Payroll taxes arise from both the employee and the employer. If you own a business and have employees, as an employer, you are legally mandated to withhold, file, and remit a certain percentage of your employees salaries or wages. Additionally, you should also match this contribution.

Payroll tax liability falls under the Federal Insurance Contributions Act (FICA) of IRS and consists of two types of taxes: Medicare tax and Social Security tax. Social Security tax helps to cater for one's disability, survivorship as well as retirement while Medicare tax caters to one's hospitalization bills.

payroll taxes

The IRS sets the percentage of tax to withhold from an employee. For 2019 taxes, the total FICA percentage from the employee is 7.65. This comprises of 6.2% of Social Security tax and 1.45% of Medicare tax. The employer matches this contribution, which makes the total FICA contribution from both parties 15.3%.

For example, if you were earning $60,000, your total contribution as an employee to the payroll tax is $4,590.00 (7.65% * 60,000). This is made up of 3,720 (6.2% * 60,000) of Social Security tax and $870 (1.45% * 60,000) of Medicare tax.

If you are the employer, you will also match these amounts as part of the employer contributions for all your employees.

However, employers should withhold an extra 0.9% of individuals with more than $200,000 of wages in a year and $250,000 for couples filing jointly for Medicare tax. This additional tax amount is only born by the employee.

Self-employment tax liability

Tax liabilities for self-employed people are not that different from the payroll taxes. It also consists of Medicare and Social Security taxes.

The only difference is that you are responsible for both the employer and the employee contributions of FICA. Self-employment means that you work for yourself, and thus, the taxing authorities will treat as an employee and employer.

Additionally, the SE tax applies to:

  • Anyone with net earnings of more than $400 per quatre, excluding a church employee.
  • Anyone earning more than $108.28 per quatre as a church employee.

Also, the IRS requires you to include your SECA tax in the estimated quarterly payments of your income tax if you have more than $400 net income in a quatre. This is because withholding taxes do not apply to self-employed individuals.

irs

Self-employment tax (SE tax) rate is also 15.3%, where 12.4% is for Social Security and 2.9% is for Medicare. However, according to the Self-employment Contributions Act (SECA), only the first $132,900 of your net income will be subjected to the Social Security tax, up to a maximum of $16,480.

For Medicare tax, any income above $200,000 for individuals and $250,000 for married couples filing jointly are subject to an extra 0.9% tax.

Figuring how much of the SE tax to pay is quite easy since you will be using Form 1040 to file your returns.

It is important to note that the SE tax applies to any self-employed individual, even if you have reached retirement age and are receiving Medicare or social security.

Estimated tax liability

According to the IRS, one must file and pay taxes on income as they receive or earn it throughout the year. Employers withhold for their employees as payroll taxes, but as a self-employed person, no one withholds part of the money you pay yourself from the business earnings. As such, you must pay the estimated tax to the IRS.

tax liability

Estimated tax liability will also arise from any other income you receive, such as interest earnings, alimony, dividends, awards, and prizes. The IRS requires quarterly payments of estimated tax liability is paid quarterly: by 15th April, 15th July, 15th September, and 15th January of the following year.

Income tax liability for businesses

Businesses pay income tax from their net income or profit. The net income is all the income a company has earned after deducting business expenses. Filing and paying this tax, however, will depend on the type of business.

Sole proprietorships, partnerships, S- Corporations, and single-member LLC owners file and pay their business income taxes through their individual tax returns. This is referred to as pass-through-tax.

If your business is a single-member LLC or a sole proprietor, you will use Schedule C of form 1040 to file your personal and business returns. If you are in a partnership, you will use the partnership business tax return to file your business income tax returns.

Then you will pay this income tax based on your share of the profits when doing your personal returns.

The situation is different for C Corporations since it is a separate legal entity. As a legal entity, taxing authorities will treat the income tax for your business separately from your individual taxes.

You will, therefore, file and pay 21% of your business profits as federal corporate tax. Apart from the federal corporate tax, some states charge state corporate tax, and the rate depends on the state.

Sales tax liability

The sales tax liability is a tax obligation that arises from the sale of goods and services. Sellers of goods and services collect the sales tax on behalf of the taxing authority and the point of purchase. After collecting the sales tax, one should file, and remit this money to the taxing authority.

sales tax liability

The sales tax rate will vary from state to state. Also, what is taxed varies between states. Given the sales tax rate, you can calculate the sales tax liability by multiplying the tax rate with the total bill. For example, let's assume every product in your store is subject to a sales tax of 16%. If a customer buys goods worth $1000, then the sales tax to file and remit to the revenue authority is $160 (16% * $1000).

In most states, goods and services sold online are now subject to sales tax, so it would be ideal to confirm the rates in your state if you have an online store.

Property tax liability

Property tax liability applies to businesses that own real property, i.e., real estate like land and buildings. Local governments charge property taxes. As such, the rates for property tax vary from one state to the other.

Additionally, the value of your property will also determine how much property tax you will pay to the taxing authority.

To calculate your property tax, check the annual rate your local government charges, and multiply this with the total value of your property. Say, for example, your business owns a piece of land. Upon assessment, the market value is $500,000. Assuming that your state's property tax rate is 20%, then your property tax liability will be $100,000 (20% * $500,000).

Capital gain tax liability

It arises from the profits you make when you sell any business asset, apart from inventory. This could be a sale of land, building, investments like bonds, stocks, or precious metals. The gain is the difference between how much you are selling the asset and the price that you bought it.

capital gain

Example: let's assume you bought a piece of land at $500,000 3 years ago. The current assessment of the property shows it has a market value of $700,000. If you were to sell this land at the current market value, you would have a gain or profit of $200,000. If your state's capital gain tax rate is at 8%, then your capital gain tax liability will be $ 16,000 (8% * $200,000).

Excise tax liability

These are not to be confused with the sales tax liabilities we discussed above. Businesses pay excise tax liabilities for some specific activities like wagering or consumption of certain items like fuel. This tax liability is usually part of the products or service price. It is also remitted to the IRS.

Gross receipt tax liability or Turnover tax liability

Some states like Texas and Nevada charge businesses gross receipts tax instead of income tax. Local governments that charge gross receipt tax charge it on the gross revenue, also total sales of the company. This is before the deduction of any business expenses.

Tax deductions

Once you are aware of the tax liability, you should file and remit the money before the deadlines. With proper tax planning strategies, you can legally reduce your tax liability and pay less tax.

Tax deductions are one of the ways of reducing your taxable income. Self-employed individuals can reduce their liability by claiming part of the employer's contribution when calculating their gross income. Additionally, one can either claim a standard tax deduction or itemize qualifying deductions. However, you cannot do both.

tax deductions

The standard tax deduction is the amount of tax that the IRS allows you to deduct from your income to help reduce your tax liability, no questions asked. For the year 2019, the standard tax deductions are:

  • Filing as a single person- $12,200
  • Filing separate returns but are married- $12,200
  • For the head of the house- $18,350

If you go with the option of itemizing your deductions, you can reduce your tax liability by claiming the below expenses:

  • Donations made to charities to a tune of 60% of your Adjusted Gross Income (AGI).
  • Health care expenses. It also includes your dental expenses. You can claim any amount over 10% of your AGI.
  • Prepaid taxes. This is for taxes prepaid to both the local and state government up to $10,000 for those filing as single individuals and $5,000 for married couples filing separately. If you paid sales tax instead, you could substitute if for income tax if it helps reduce your tax liability even more.
  • Interests paid during the year. Like investments and mortgage interest. However, it is essential to note that mortgage interest is limited to $750,00 for single filers and $350,000 for married couples filing separately. Also, the funds must have gone towards constructing, purchasing, or making substantial improvements to your primary or secondary residences.
  • tax deductions
  • Any losses from theft. These are expenses that result from any disasters declared by the federal government. Keeping tabs of these itemized tax deductions is not as simple as it seems. One of the tax planning strategies to do is to keep track of these expenses as they occur in excel or using tax planning software.

If your itemized deductions are more than the standard deduction, you can claim the higher of these two.

Tax credits

Tax credits will also reduce your tax liability. A tax credit is applied directly to the tax liability. If you have a tax claim from the previous year, you can use it to reduce your current tax liability. Assuming you have a tax liability of $2000 and a credit of $800, when you apply for the tax credit, you will have a tax liability of $1200 (2000 - $800).

References

https://www.investopedia.com/terms/s/seca.asp

https://www.investopedia.com/terms/f/fica.asp

https://www.patriotsoftware.com/blog/payroll/what-are-payroll-taxes/

https://www.thebalance.com/tax-planning-basics-3193487

https://www.patriotsoftware.com/blog/accounting/tax-liability/

https://www.thebalancesmb.com/all-the-taxes-your-business-must-pay-399045

https://www.thebalance.com/what-are-tax-liabilities-4159519

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