Definition: A deferred income tax liability is income tax that a corporation owes but is put off into future years because of a difference between GAAP accounting and income tax accounting. This can be a difficult concept for beginners, but it is actually quite simple. IRS tax rules and GAAP aren’t always the same.
What Does Income Tax Liability Mean?
For example some expenses are nondeductible according to the IRS, but GAAP allows them to be deducted from income. This leads to differences between book or GAAP net income and tax or IRS net income. This is most often called a book to tax difference.
Since corporations are taxed on their profits or net income, the taxes owed on the tax return could be different than the book taxes owed.
Some book and tax differences are permanent and some are temporary. For instance, the IRS only allows a tax deduction for half of meals and entertainment. GAAP allows an expense for the full amount. This is a permanent difference that will never be resolved.
Example
Income tax liabilities are deferred to future periods if the book and tax differences are temporary and are resolved in future years. Depreciation is a good example of a temporary difference. The IRS allows deductions for accelerated depreciation under Code Section 179. This means that a company could depreciate the entire cost of an asset in the year of purchase. GAAP requires that revenues be matched with expenses and only allows for depreciation over the useful life of the asset.
In other words, for tax purposes the company and deduct all five years worth of depreciation of an asset in the year of purchase. GAAP requires the five-year asset to be depreciated over the five-year period. The initial tax depreciation is higher and the taxable income is lower than the book income in the first few years. At the end of the five years, both tax and book accumulated depreciation will be the same because the asset if fully depreciated.
Since this timing difference is only temporary, GAAP allows companies to deferred income taxes for financial accounting and expense them in future years.
