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How to Read a Financial Report: Wringing Vital Signs Out of the Numbers by John A. Tracy

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11
INCOME TAX EXPENSE AND
ITS LIABILITY
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74 Income tax expense and its liability
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 bal-
ance 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 com-
pany 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 part-
nership or limited liability company). A corporation, being
a separate person in the eyes of the law, has several important
advantages. However, profi t - motivated business corporations
have one serious disadvantage they are subject to federal and
state income tax on their profi ts, or, to be more accurate, they
owe tax based on their taxable income , which is profi t 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 cor-
porations, 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 taxable income in their indi-
vidual income tax returns for the year. In this way these entities
avoid the so - called double taxation of business profi t rst in the
hands of the business corporation, and second in the hands of its
stockholders (to the extent that net income is distributed as cash
dividends to them).
The fi rst point to keep in mind is that a business corporation
must earn taxable income to owe income tax. The simplest way
to pay no income tax is to have no taxable income, or to have a
loss for tax purposes. Of course a business wants to earn profi t,
but earning a profi t comes with the burden of sharing its pretax
profi t with Uncle Sam and with the states that levy a tax on busi-
ness profi t earned within their borders.
A second point to keep in mind is that there are many loop-
holes and options in the federal income tax code to say nothing
about state income tax laws that reduce or postpone income
tax. I m sure that you re aware of the complexity of the federal
income tax law. That s an understatement, if I ve ever heard one.
It takes thousands of pages of tax law to defi ne taxable income.
Most businesses use income tax professionals to help them deter-
mine their taxable income, and to advise them how to minimize
the income taxes they must pay. In any one year, a business
might take advantage of several different features of the tax code
to minimize its taxable income for the year, or to shift taxable
income to future years.
For the business example, I have to simplify. The business
pays both federal and state income taxes based on its taxable
Federal and State Income Taxation of Business Profi t
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