The Impact of Income Tax Liability on Your Balance Sheet

  • Accracy
  • 26th Nov, 2023

As a business owner, you're responsible for maintaining financial statements that report on what your business makes, spends, owns, and owes. But when do you need to provide them to the IRS and state departments of revenue?And how are they used as part of your tax filing?

The Impact of Income Tax Liability on Your Balance Sheet
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We've got the rundown on these questions, including what you need to know about a balance sheet and how it could impact your income tax liability.

What is a balance sheet?

You can think of the balance sheet as a snapshot of your businesses finances at a point in time. It shows you what you own (assets), what you owe (liabilities), and what has been invested in the company (equity).

A balance sheet is one of three main financial statements businesses use to understand their financial health, the others being an income statement and cash flow statement.

You would use an income statement and cash flow statement to understand the revenue and expenses of your business. Then, abalance sheet shows you the end result (including bank and credit card balances) of that activity.

 

What is income tax liability?

Your income tax liability is the taxes you owe based on what you earned. You most likely need to pay income taxes on both the federal and state level with the taxes from each going towards programs like building infrastructure or funding education.

The amount of income taxes you owe is calculated using what's called your taxable income. Taxable income is all of your personal earnings, and your business's earnings including sales, income from interest generated, and some types of unearned income.

For example, let's say your business made $200,000 in sales over the year. In that same time frame, the business earned $10,000 from investments and accumulated $50,000 in tax deductions. The calculation looks like this:

$200,000 + $10,000 - $50,000 = $160,000 taxable income

Income tax liability and the balance sheet

Generally speaking, your balance sheet does not provide any information on your income tax liability. Since your taxable income is calculated using revenue and expenses, you need to use a financial statement that holds that information: an income statement.

This doesn't mean your balance sheet has no impact on your tax filing process. In some cases, you'll be required to provide a balance sheet as part of the state or federal tax filing process.

How a balance sheet affects income tax liability

Sole Proprietorship or LLC filing taxes as a sole proprietor

When you file as a sole proprietorship, you're essentially saying that you and your business are the same entity. Instead of filing a separate tax form, you submit a "schedule"—an additional document you attach to your tax return. In the case of your federal tax return, you submit a Schedule C which reports information about your incomes and expenses which are found on your income statement.

While the information on your balance sheet may be helpful as part of the tax filing process, the information on it will not affect your income tax liability.

Partnerships, LLC filing taxes as a partnership, S-Corporation or C-Corporations

Federal taxes

For businesses that file as separate entities, there are specific tax forms depending on what you're filing as.

Partnerships file Form 1065 which summarizes its net income broken up into the income and tax deductions found on your income statement. These earnings and deductions then "pass-through" to the partners who report that income on their personal tax returns. This means the information on your balance sheet does not affect your income tax liability. However, you must fill out Schedule L to report all the items on your balance sheet.

C corporations and S corporations file Form 1120 and Form 1120-S respectively. Like other forms mentioned, they report your income and tax deductions to calculate your final tax bill. Both forms require a Schedule L that reports everything on your balance sheet, but it doesn't affect your tax liability.

Why does the IRS require a balance sheet if it doesn't affect your income tax liability? It's being used as an additional step of verifying the income and tax deductions you present. For example, if you have a mortgage on your balance sheet but no interest expenses, the IRS might treat that as a red flag that the reporting is inconsistent and trigger an audit.

State taxes

A balance sheet may affect your tax liability at the state level. In particular, this can affect franchise taxes in certain states. Remember, franchise taxes are not an income tax, rather they're a separate tax paid to the state for the privilege of doing business there.

While there are different methods to calculate franchise taxes by state, some opt for taxing based on the business's net worth or total assets. The net worth of the business is found by looking at the assets it owns as reported on the balance sheet.

An example of this is the state of Delaware. Delaware has two methods of calculating franchise taxes and the assumed par value capital method uses total assets in the first step of the calculation. The total assets number you use must match the total assets as reported on Schedule L of Form 1120.

Not every state charges a franchise tax. Of the 18 states that charge a franchise tax, only the following 10 states require you to report your assets with implications on your liability:

  • Arkansas: If your assets are under $100,000,000, the franchise tax is $300, otherwise it is $400.
  • Delaware: If you use the assumed par value capital method, you report your total assets in the first step of the calculation.
  • Georgia: You must pay a net worth tax that is based on the assets you hold in Georgia or a proportion of assets like cash, accumulated depreciation, and accounts receivable based on the percentage of business conducted in Georgia.
  • Illinois: The franchise tax is based on what percentage of your assets are based in Illinois. The money value of your assets does not affect your taxes, rather how much of that money value is in the state.
  • Mississippi: You pay a dollar amount per $1,000 of the value of the capital used in the state, or assessed property value in the state (whichever is bigger).
  • Missouri: The franchise tax you pay is based on your total assets or issued stock (whichever is bigger), but you do not need to pay franchise taxes if your total assets in Missouri is less than $1,000,000.
  • New York: The business must pay the highest of three tax calculations. The tax is either a flat rate, a percentage of business income collected in the state, or a percentage of assets used in the state.
  • North Carolina: While it differs by entity type, for corporations the tax amount is based on the company's net worth as based on the assets held.
  • Oklahoma: The franchise tax is based on the total capital held within the state.
  • Tennessee: The franchise tax is based on the net worth or total property held by the business within the state.

The Bottom Line

A balance sheet is an integral financial report for businesses of all sizes. In some cases, they're a required document as part of your tax filing process. But beyond that, it's an easy way to see what your business owns and owes without jumping from account to account to figure it out.

With Accracy, you get an intuitive dashboard and interactive reports that don't just keep you tax compliant, but helps you better understand your financial health.

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