Income Tax Expense

Income tax expense is the amount of tax a company reports as an expense on its income statement for a period, based on the profit it has recorded under its accounting framework. It is shown below income before taxes, and subtracting it gives net income. Income tax expense is not simply the tax the company owes to the government for the year. It has two parts: current tax, which is the tax payable on the period's taxable income, and deferred tax, which reflects tax effects that will reverse in future periods.

The difference arises because financial accounting and tax law measure income differently. Accounting follows US GAAP or IFRS, while taxable income follows the tax code. Some differences are permanent, such as fines that are never deductible, and some are temporary, such as faster depreciation for tax than for book purposes. Accounting for income taxes is governed by ASC 740 in US GAAP and IAS 12 under IFRS.

The basic relationship is:

Here $\text{Current tax expense}$ is the tax due for the period based on taxable income at enacted rates, and $\text{Deferred tax expense}$ is the net change during the period in deferred tax liabilities and deferred tax assets, adjusted for any valuation allowance. Deferred tax expense can be negative, in which case it is a deferred tax benefit that reduces total income tax expense.

A US manufacturer reports pre-tax income of $5,000,000 for the year. Its tax depreciation exceeds book depreciation by $400,000, a temporary difference, and it paid $50,000 of non-deductible penalties, a permanent difference. Assume a combined federal and state tax rate of 25 percent.

• Taxable income is $5,000,000 minus $400,000 plus $50,000, which equals $4,650,000.
• Current tax expense is 25 percent of $4,650,000, or $1,162,500, recorded as a liability until paid.
• The $400,000 temporary difference creates a deferred tax liability of 25 percent of $400,000, or $100,000, which is deferred tax expense.
• Total income tax expense is $1,162,500 plus $100,000, which equals $1,262,500.

The journal entry debits income tax expense for $1,262,500, credits income taxes payable for $1,162,500 and credits the deferred tax liability for $100,000. Net income is $5,000,000 minus $1,262,500, or $3,737,500.

The effective tax rate is income tax expense divided by pre-tax income. In the example it is $1,262,500 divided by $5,000,000, or 25.25 percent. It differs from the statutory 25 percent because of the non-deductible penalties; temporary differences alone do not change it, since deferred tax captures their effect. Public companies must provide a reconciliation between the statutory rate, which for US federal corporate tax has been 21 percent since the Tax Cuts and Jobs Act of 2017, and their effective rate, explaining items such as state taxes, foreign rate differences, tax credits and changes in valuation allowances. ASU 2023-09 expanded these disclosures, requiring more detailed rate reconciliations and taxes paid by jurisdiction.

Income tax expense is often confused with taxes paid. The cash flow statement or notes show cash taxes paid, which can differ greatly from the expense because of deferred taxes, timing of payments, refunds and credits. A company growing rapidly with heavy capital spending may pay much less tax than its reported expense for years, a pattern visible in a growing balance of deferred income taxes.

Other items to be aware of include uncertain tax positions, for which companies must record a liability if a tax benefit is not more likely than not to be sustained on examination; valuation allowances, which reduce deferred tax assets that are unlikely to be used; and the effect of tax rate changes, which are recognized in the period the change is enacted. Since 2024, many large multinationals have also faced the 15 percent global minimum tax under the OECD's Pillar Two rules in the countries that have adopted it. Income tax expense does not include sales taxes, payroll taxes or property taxes, which are operating costs, or the withholding tax a company collects on behalf of employees. The broader subject of taxes on profits is covered in the entry on income tax, and the tax rate applied to the next dollar of income is the marginal tax rate.