How to account for the payment of income taxes

December 5, 2012

Income taxes are usually a significant expense of a company. For example, many corporations pay income taxes in 30-40% range. In this article, we will discuss a basic concept that applies to the payment of federal, state, or local income taxes. We will limit our discussion to taxes paid by corporations. We will not cover, in this article, temporary differences and the allocation of income taxes between financial statement periods. These topics will be discussed in later articles.

1. Corporations and income taxes

Corporations are separate legal entities, and as the result, they pay taxes in their own names similar to individuals. Corporations are taxable entities that must pay federal income taxes; and depending on the location, corporations might be required to pay state and local income taxes in addition to federal income taxes. Most corporations pay federal income taxes in four (4) installments throughout the year. That is, corporations are required to estimate their federal income taxes for the forthcoming fiscal year and pay the estimates in four installments during the year.

Each installment payment of federal income taxes is recorded as a:

  • Debit to Income Tax Expense, and
  • Credit to Cash

At the end of the fiscal year, a corporation will determine its actual income taxes based on its income or loss that year and determine whether income taxes were under- or overpaid.

  • Income tax underpayment: the amount of income taxes paid throughout the fiscal year is less than the actual tax liability. In this case, the company will debit Income Tax Expense (i.e., for amount underpaid) and credit Income Tax Payable (i.e., current liability).
  • Income tax overpayment: the amount income taxes paid is more than the tax liability. In this case, the company will debit Prepaid Income Taxes or Income Taxes Receivable (i.e., current assets) and credit Income Tax Expense.

Income tax expense is the last expense reported on the income statement: it is reported after income (loss) before income taxes and before net income (loss). Income tax expense usually does not equal the actual amount paid in taxes (i.e., cash payment). Income tax expense is determined according to financial accounting standards while the amount of taxes paid is determined by government tax regulation. For instance, U.S. corporations report financial income (loss) to stakeholders and taxable income to IRS. In addition to different regulation, income tax expense might not equal tax cash payment because expenses can be deferred to later periods.

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