How to Read a Financial Report: Wringing Vital Signs Out of the Numbers

Chapter 11. INCOME TAX EXPENSE AND ITS LIABILITY

Federal and State Income Taxation of Business Profit

Please refer to Exhibit 11.1 at the start of the chapter, which highlights the connection between income tax expense in the income statement and the income tax payable liability in the balance sheet. A small part of the company's total income tax expense for the year, which is based on its taxable income for the year, has not been paid at year-end. This remaining balance will be paid in the near future. The unpaid portion stays in the company's income tax payable liability account until paid.

The business in our example is incorporated; the business decided on this form of legal organization (instead of a partnership or limited liability company). A corporation, being a separate person in the eyes of the law, has several important advantages. However, profit-motivated business corporations have one serious disadvantage—they are subject to federal and state income tax on their profits, or, to be more accurate, they owe tax based on their taxable income, which is profit before income tax.

The business in this example is a regular, or so-called C corporation. Under the federal income tax law, small or S corporations, partnerships, and limited liability companies are "pass-through" tax entities—these entities pay no income tax themselves but instead serve as conduits. Their annual taxable income is transferred, or passed through, to their owners, who include their shares of the business's ...