If you have your financial statements prepared for lenders or investors, your accountant may have noted deferred tax assets or deferred tax liabilities on your balance sheet. These assets and liabilities can directly affect your company’s cash flow for subsequent years, so it’s important to understand what yours represent and how likely you are to realize them.
What Creates Deferred Tax Assets and Liabilities
The revenue and expenses you report on your income statement don’t always translate into income and deductions for tax purposes. Tax accounting and financial accounting have slightly different rules, which is why your business’s taxable income isn’t always the same as the net income on your financial statements.
Some of these instances result in permanent tax differences. For example, interest income from municipal bonds is excluded from taxable income, and half of meals and entertainment expense is always disallowed. Other differences are temporary. These differences have to do with timing. You’ll end up recognizing the income and expenses eventually, but you just may recognize them sooner under one system than you do under the other.
A classic example of a temporary difference is financial and tax depreciation. Both systems allow depreciation, but tax laws allow you to accelerate your depreciation faster than you can under financial accounting. That means that, in early years, you may be able to claim a $5,000 depreciation expense on your taxes even though you’ve only listed $4,000 on your income statement. Conversely, in later years, you may only be able to claim $3,000 in depreciation for tax purposes while you have $4,000 listed on your books.
Temporary timing differences create deferred tax assets and liabilities. Deferred tax assets indicate that you’ve accumulated future deductions — in other words, a positive cash flow — while deferred tax liabilities indicate future cash outflows. For corporations, deferred tax liabilities are netted against deferred tax assets and reported on the balance sheet. For pass-through entities like S corporations, partnerships, and LLCs, they appear on a supporting schedule on your business tax return.
Evaluating Deferred Tax Assets and Liabilities
It can be tricky to determine when and if you’ll be able to actually take advantage of a deferred tax asset. Tod Wagner, tax partner at Bober, Markey, Fedorovich & Company, notes that deferred tax assets “may either make a business’ financial picture look better than it really is or represent a hidden financial resource.” For example, net operating loss carryforwards are a significant type of deferred tax. These occur when your business has a net loss but isn’t able to deduct all of it. The remaining balance of the loss is carried forward until you have a high enough net income to use it. But, of course, you can’t predict the future. You don’t know what years you’ll be eligible to use the carryforwards and whether you can use them all before the balance expires.
Understanding Your Deferred Tax Assets and Liabilities
If you have deferred tax assets and liabilities, there’s a good chance that lenders, investors, or potential buyers will want to know about them. Before you meet with important stakeholders about financial matters, ask your CPA these types of questions:
- Of the netted figure on the balance sheet, what is the breakdown between deferred tax assets and deferred tax liabilities?
- What comprises the assets and liabilities? What events caused them?
- When do you expect the business will realize the tax assets and liabilities?
- How likely do you think it is the business will be able to recognize the tax assets and liabilities? Is it certain, very likely, or only somewhat likely?
If deferred tax assets aren’t listed on your balance sheet but you’ve seen them in your tax return schedules, it’s worth mentioning them to interested parties. Knowing that there’s a cushion to support the business through some rough years may make a difference in lending, investing, and purchasing decisions.