Deferred Tax Liability and Your Company's Balance Sheet
Editorial note: This blog was originally posted in 2014 and has been updated.
April 5 2022 — Defer. Defer. Defer. That is usually the name of the game for income tax strategy. What does that mean for how we look at company balance sheets?
The definition of “Deferred Tax Liability” is an account on a company's balance sheet that is a result of temporary differences between the company's accounting and tax carrying values, the anticipated and enacted income tax rate, and estimated taxes payable for the current year. They occur when items of income or expense are treated differently in financial statements than in tax returns. Assets are booked for expected future tax benefits while liabilities are recorded for expected future tax costs. This keeps future tax obligations in front of company stakeholders and financial statement users such as bankers.
Different treatments cause timing differences that are temporary in nature. Common timing differences include cash basis accounting, advance rent income, prepaid expenses, long-term contracts, depreciation methods, deferred compensation, installment sales, prepaid subscription income, bad debt reserves, warranty expense, and loss contingencies. Pass-through entities present a unique issue. S-Corp’s and LLC’s don’t pay taxes, so how can they have deferred taxes? Everyone involved in the financial results of a pass-through entity understands the entity does pay taxes on income earned. The entity pays in the form of equity distributions to its owners.
The unique issue for pass-throughs? They don’t book deferred tax distributions. There is no deferred tax on the company balance sheet to remind financial statement users of looming future tax obligations.
Common permanent treatment differences include life insurance premiums and proceeds, fines and penalties, as well as meals and entertainment. Examples of exclusions or special deductions are municipal bond interest, dividend received deduction, or percentage depletion.
Deferred Tax Liabilities and M&A Transactions
A deferred tax liability can impact the future cash flow of a non-pass-through company. Because of this, it also can impact the sales price for a business. During an M&A transaction, a savvy buyer will take into account deferred tax liabilities when figuring out how much to offer for a business.
The liability will in essence be treated like a “debt” - but with nuances. The size of the debt is based on the present value of the remaining tax payment differential over the life of the assets. So it matters how much is still owed, over how long, and what the current age of the asset is. Also, the deferred tax liability only has value if the company is expected to be profitable and owe taxes in the future. The accounting can be complex and hiring an M&A advisor to help sort it out may be wise. Deferred tax liability is the kind of thing that can sneak up on people during an M&A negotiation and disrupt a closing late in the process.
Defer for Now
The old adage with taxes is: defer defer defer. However, the value of deferred tax liability is always dependent on the current tax code and the various taxation rates. This means if there are significant changes passed in Washington, it may make sense to reconsider your tax deferral strategy.
Sean Sullivan specializes in both creative and strategic marketing initiatives. Key areas of expertise include lead generation and new customer acquisition, content development, project management, art direction, and multi-channel campaign implementation. A process-oriented strategic thinker, Sean is adept at translating ideas and key messages into actionable insights and effective customer-focused marketing communications. Prior to joining Redpath and Company, Sean served as a Marketing Account Manager at C.H. Robinson where he balanced a number of responsibilities including driving revenue growth, building brand awareness, utilizing multi-channel marketing tactics, and leading high profile, cross-functional projects such as brand integrations and global tagline development.
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