How To Calculate Provision for Income Taxes and What It Means

Provision for income taxes is an amount that a company expects to pay as income taxes. Calculating this starts with estimating the total pre-tax income to adding deferred income tax expense. It’s important to understand this if you run a business. Putting this estimate together can help with your financial statements and help you comply with tax laws.

To put together your financial statements, your payroll records need to be in order. You can create your pay stubs with a reliable paystub generator to make the process easier.

In this guide, we will explain what provision for income taxes means and how to calculate the provision for federal income tax. You’ll also learn how deferred tax works and some accounting best practices.

What Is Provision for Income Taxes?

Provision for income taxes is the amount that a business expects to pay in income taxes. This figure is usually an estimate and applies to the current year. It appears on the income statement as income tax expense. On the current year balance sheet, it shows up as a tax liability or income tax liability. And it shows a company’s financial health.

Provision for Income Taxes Meaning

Provision for income taxes is the total amount that the company estimates as its income tax liability. That includes the amount that they owe right now and any deferred tax expense. Companies come up with this number even though they don’t pay their taxes until it’s time to file their tax returns. The income tax provision follows generally accepted accounting principles and is important for financial planning. 

Read More: Payroll Record-Keeping for Business Owners

Income Tax Provision in Financial Statements

Tax provisions have an impact on the income statement as well as on the balance sheet. On the income statement, provision for income taxes appears after the operating income. They use this number to calculate the net income of the business.

On the balance sheet, current income tax expense shows the taxes that the company owes for that year. This is based on the taxable income they have for the year. Deferred tax assets and deferred tax liabilities show the future tax effects.

Check Out: Create W-2 forms for employees with our online W2 generator

How To Calculate Provision for Federal Income Tax

Now that you understand the provision for income taxes, you need to calculate it. Here is a step-by-step guide you can follow to arrive at the estimated amount you need in line with income tax accounting rules:

Step 1: Start With Your Pre-Tax Income

Begin with the total amount you have before taxes. You can get this from the company’s income statement. It’s also called income before taxes or accounting income. 

Step 2: Adjust for Permanent Differences

Next, identify your permanent differences. The permanent differences are items that are treated differently for accounting and tax purposes. And they never reverse. Add the non-deductible expenses, such as penalties and fines. Take out any tax-exempt income, like bond interest. Now, your taxable income has changed.

Step 3: Adjust for Temporary Differences

After you’re done with permanent differences, you need to account for temporary differences as well. These are items that are recognized in different periods for books and taxes. However, these ones eventually offset future taxable income. 

Step 4: Apply the Applicable Tax Rate

After adjusting for both permanent and temporary differences, you now have your current year's taxable income. Now, you’ll multiply this by the applicable corporate tax rate to get your federal income tax expense. If there are any tax law changes, you have to recalculate your deferred tax assets and liabilities with the new rates. 

Step 5: Apply Tax Credits and Net Operating Losses

Subtract any tax credits or certain tax benefits that are available to you. These usually reduce your tax bill dollar-for-dollar. For example, research and development credits or energy credits. Then, apply your net operating losses from previous years. This can offset up to 80% of current taxable income under the current tax law.

Step 6: Calculate Your Current Income Tax Expense

After taking out tax credits and net operating losses, you arrive at your current income tax expense. This is the amount you owe for the current year. So, you know your actual tax payment obligation and how it affects cash flow. And this can help you make correct tax payments. 

Step 7: Add Deferred Income Tax Expense

Finally, you should calculate deferred income tax expense. Do this by comparing your deferred tax assets and tax liabilities at the beginning and end of the same period. The change reflects the tax impact of temporary differences. Add that number to your current tax expense. That is your total provision for federal income tax, which shows up on your financial statements. 

Also Read: A Full Guide on the 3 Types of Taxes and What They Mean For You

What Is Deferred Tax?

Deferred tax shows the future tax implications of temporary differences. When it’s favorable, it’s recognized as deferred tax assets. When it’s unfavorable, it’s recognized as deferred tax liabilities. This affects the company’s GAAP (Generally Accepted Accounting Principles) balance sheet, which impacts financial position and cash flow.

Deferred Tax Assets and Future Tax Benefit

Deferred tax assets represent the future tax benefits that you can get due to some situations. They happen when you pay taxes now, more than your financial statements show. It can also come up if you may get tax deductions in the future.

An example is net operating losses, which you can use to reduce future taxes. Another is warranty expenses that you already have written down in your books, but you can’t claim until you pay those warranty claims. 

If you run a business, you need to determine if you’ll have enough future taxable income to use the benefits. Otherwise, you have to create a valuation allowance. Any changes you make to this valuation allowance will affect your deferred income tax expense. It will also impact your income tax provision.

Deferred Income Tax Expense

Deferred income tax expense just shows how much your deferred taxes changed during the year. To calculate it, you need to compare your deferred tax assets and deferred tax liabilities. You look at the numbers at the beginning of the year compared to the end of the year. 

The calculation requires you to identify all common temporary differences. Then, you use the applicable corporate tax rate and determine the net change. Your business has to track where each temporary difference came from and when it’s expected to reverse. Do this to ensure financial statements accurately reflect the correct financial data.

Further Reading: Budgeting for Business: Common Mistakes and How To Fix Them

Tax Accounting Best Practices

Good tax accounting means having competent individuals implement the right procedures. This can make sure you have an accurate provision for income taxes.

Strong Tax Department

The tax department has an important role to play when it comes to tax provisions and compliance. Firstly, they manage tax payments and tax reporting. They liaise with the accounting department to ensure that the tax provisions are in line with the operations of the company. They also stay abreast of the tax law changes to ensure that the business stays on the right side of the law.

Tax Planning 

Intelligent tax planning can, in fact, reduce the tax that you pay and still keep you compliant. It involves analyzing transactions and finding opportunities to help you plan taxes. For example, reducing operating expenses or entertainment expenses. Maybe to even defer income. It also includes structuring operations in order to reduce the tax burden on the business.

Financial Reporting 

Accurate financial reporting of tax provisions is important for compliance. To endure this, you need to have strong internal controls. Everything should be reviewed thoroughly. This ensures your financial statements show accurate numbers for your company’s net income. It’s also good for financial transparency.

There should be schedules that track temporary differences. You should also reconcile tax accounts periodically and evaluate uncertain tax positions. 

Income Tax Provision Software

Good tax departments leverage corporate tax provision software to do the heavy lifting. The software can help you calculate income tax provision. They can automate the calculations, track temporary differences, and reduce errors. If you use quality software, it can connect to other accounting systems and even handle state taxes. This allows the team to concentrate on strategy and manage tax obligations.

Check Out: Make pay stubs with our free paystub templates to simplify tax preparation

Wrapping Up

Now, you know what provision for income taxes means and why they’re important. Tax provisions are useful for proper financial reporting, tax planning, and compliance with laws. By implementing best practices, you can ensure that your business has the right records and is set up for success.

Besides tax provisions, you need other financial documents, such as pay stubs, for proper reporting. Our pay stub maker can help you create accurate pay stubs in minutes. Leave pay records to us and focus on tax planning for your business.