September 11, 2020
What is a Tax Liability
What is a Tax Liability
In short, your tax liability is the total amount of tax you are responsible for paying to the IRS.
There are many things that contribute to your tax liability, for example income tax, capital gains, self-employment and the dreaded, penalties and interest.
Throughout this article, we will go through the different types of liabilities and some examples in hopes of helping to make it a bit easier to understand.
What is Tax Liability?
Your tax liability is a tax debt owed to a taxing authority, like the IRS. If you pay taxes on it, it’s a tax liability. For many, we pay taxes on our income. Our employer withholds a certain amount from our paycheck, or if we are self-employed, we are paying as an estimated tax. If the amount withheld or paid into the system is not enough, we are responsible for making up the difference, typically by paying the amount due by April 15.
In addition, there are some deductions that would reduce our tax liability, such as taking the standard deduction, or itemizing our deductions, such as mortgage insurance, medical and dental expenses, charitable contributions, etc.
Depending on your filing status and tax bracket, will determine your tax liability, but we’ll go through more of that later on.
Some examples of tax liabilities are:
- Earned Income
- Business Tax
- Self-employment Tax
- Payroll Tax
- Capital Gains Tax
- Property Tax
Types of Tax Liabilities
- Back Taxes
This tax liability means your or the business tax liabilities are not limited to only one year, but two or more. These tax liabilities can really begin to add up as penalties and interest continue to accrue. Depending on the penalty, it can range from 5% up to 25% of the unpaid tax. The interest rate is the federal short-term rate plus 3%. In addition, it compounds daily and is determined and posted every three months.
- Capital Gains Tax Liability
If you have an asset that you sold for more than its original purchase price, you must pay tax on the difference between the sale price and original purchase price; this is capital gains tax. If you have owned this asset for more than one year, then this is long-term capital gains and you would pay tax on the profits, depending on your tax bracket.
For example, you purchased a painting several years ago for $10,000. In 2019 you sold this painting for $20,000. The difference is $10,000; therefore, you would need to pay tax on that $10,000, not the $20,000.
As this is a general example, it can be a complicated tax as the tax rate for this tax liability may be different from other tax calculations. If you are not sure or have any questions, it’s best to contact a tax professional who has the knowledge to help you navigate through this.
- Income Tax Liability
Ah, the income tax liability. This is the tax many are familiar as it is the most common. Our income tax owed depends on three things, our tax rate, filing status and taxable income bracket. For the tax year 2020, there are seven tax brackets. Here is an example of how this can vary from one family to another depending on those three items:
Jimmy is single and earns $90,000 per year. This places him in the 24% tax bracket; therefore, he will owe $15,680 in income tax liability.
Jimmy is married and filing a joint return and earns $90,000 per year, his wife is just starting her business, so no income to report (or expenses to make this easier). This places them in the 22% tax bracket; therefore, he will owe $11,380 in income tax liability.
If Jimmy were married filing separately, this would look the same as if he were filing single.
If Jimmy were filing as head of household, he would again be in the 24% tax bracket; therefore, he will owe $14,238 in income tax liability.
Here is the 2020 Tax Bracket we used for Single Filers:
|
Tax rate |
Taxable income bracket |
Tax owed |
|
10% |
$0 to $9,875 |
10% of taxable income |
|
12% |
$9,876 to $40,125 |
$987.50 plus 12% of the amount over $9,875 |
|
22% |
$40,126 to $85,525 |
$4,617.50 plus 22% of the amount over $40,125 |
|
24% |
$85,526 to $163,300 |
$14,605.50 plus 24% of the amount over $85,525 |
|
32% |
$163,301 to $207,350 |
$33,271.50 plus 32% of the amount over $163,300 |
|
35% |
$207,351 to $518,400 |
$47,367.50 plus 35% of the amount over $207,350 |
|
37% |
$518,401 or more |
$156,235 plus 37% of the amount over $518,400 |
Here is the 2020 Tax Bracket we used for Married Filing Joint Filers:
|
Tax rate |
Taxable income bracket |
Tax owed |
|
10% |
$0 to $19,750 |
10% of taxable income |
|
12% |
$19,751 to $80,250 |
$1,975 plus 12% of the amount over $19,750 |
|
22% |
$80,251 to $171,050 |
$9,235 plus 22% of the amount over $80,250 |
|
24% |
$171,051 to $326,600 |
$29,211 plus 24% of the amount over $171,050 |
|
32% |
$326,601 to $414,700 |
$66,543 plus 32% of the amount over $326,600 |
|
35% |
$414,701 to $622,050 |
$94,735 plus 35% of the amount over $414,700 |
|
37% |
$622,051 or more |
$167,307.50 plus 37% of the amount over $622,050 |
Here is the 2020 Tax Bracket we used for Head of Household Filers:
|
Tax rate |
Taxable income bracket |
Tax owed |
|
10% |
$0 to $14,100 |
10% of taxable income |
|
12% |
$14,101 to $53,700 |
$1,410 plus 12% of the amount over $14,100 |
|
22% |
$53,701 to $85,500 |
$6,162 plus 22% of the amount over $53,700 |
|
24% |
$85,501 to $163,300 |
$13,158 plus 24% of the amount over $85,500 |
|
32% |
$163,301 to $207,350 |
$31,830 plus 32% of the amount over $163,300 |
|
35% |
$207,351 to $518,400 |
$45,926 plus 35% of the amount over $207,350 |
|
37% |
$518,401 or more |
$154,793.50 plus 37% of the amount over $518,400 |
- Payroll Tax Liabilities
A business with employees is required to withhold certain taxes from their employee’s paycheck, known as payroll tax. These taxes are Federal Income, Medicare and Social Security, also known as FICA. The FICA taxes, Medicare and Social Security, are paid a total percentage of 7.65%, which is divided into 6.2% for Social Security and 1.45% for Medicare.
- Property Tax Liability
If you own property, you must pay property tax. This tax is calculated by a local government where the property is located and does change year by year, depending on the market values in your area. In year 2020, most state property taxes are up as market values have increased. Typically, the owner of the property will pay a different amount each year, some years may be a minute change, but its rare it will remain the same for next year.
- Self-Employment Tax Liability
As you are self-employed, there isn’t an employer to pay taxes for you. So, you are responsible for paying Social Security and Medicare taxes for yourself, which is 15.3% of your income.
In addition, you are not taking out taxes for Federal Income, therefore, you will need to make Estimated Tax Payments each quarter to ensure you will not have a large tax bill at the end of the year. It’s a good idea to sign up for the EFTPS system as it will make this much easier.
- Sales Tax Liability
These taxes are collected at the point of sale, versus being owed later on a tax return. Sales tax is what you pay to a retailer, which they then pass along to the Federal, State and local governments.
You pay sales tax on just about everything you purchase from a retailer, such as gas, food, beauty salons, clothes, cars, shoes and the list goes on.
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How to Determine Tax Liability
As explained above, American uses a progressive tax bracket and there are seven tax brackets ranging from 10% to 37%. Depending on your filing status, income and tax bracket will determine your tax liability, but this calculation does not determine what taxes you actually owe.
If you have your Form 1040 handy, jump down to Line 23, which will read, “Amount you owe.”
How to Reduce Tax Liability
To reduce your tax liability, there are several deductions which can assist in that reduction. Of course, which ones that are available for you to use all depends on a number of things, which we will go through in a minute.
First, when reviewing our tax liability, there are two main numbers. If you have your Form 1040 handy, on Line 8b, there is a calculation for your total income. Note, this is not the amount of income you will be paying tax. Scroll on down to Line 9 and you will see the key word “deductions.” The most common is to take a standard deduction.
For the 2019 tax year, the standard deduction for single taxpayers is $12,200. For example, if you earned $90,000, your taxable income would drop to $77,800 after the standard deduction is applied.
Keep going down the return to Line 11b, Taxable Income. This is the amount of income you will pay tax on as this is your true tax liability.
If you choose to itemize your deductions, using Schedule A, here are some of the deductions you could take:
- Mortgage interest
- Charitable contributions
- Medical and Dental expenses
- Sales and Property taxes
- Business use of your home
- Self-employment deduction of 50%
Tax credits can also reduce your total tax liability and are different from deductions. Deductions decrease the amount of income which you can be taxed on and tax credits decrease what you actually owe the IRS directly.
Confusing, yes. Let’s give an example. You prepare your return and using all the deductions available, you find you will owe the IRS $4,000. You have one child and therefore the Child Tax Credit is $2,000 per child, thereby reducing what you owe to $2,000.
It’s important to note, not everyone will qualify for these tax credits as they are based on income and filing status. Some common tax credits include:
- Child Tax Credit
- Child and Dependent Care Credit
- Earned Income Credit
- Lifetime Learning Credit
- Residential Energy Tax Credit
Of course, if the credits bring your amount owed to a negative, that is an overpayment which the IRS will refund to you either via check or direct deposit. Additionally, if you have overpaid into the system, a refund will also be sent. Remember to file your returns on time as there is a Statute of Limitations on Returns that are filed late.
Paying Your Tax Liability
If you do end up with a tax liability, it’s important to pay the balance due right away or make arrangements with the IRS to do so. Ignoring the IRS is not a good idea as that can lead to Federal Tax Liens, bank levies, wage garnishments, etc.
Taxes are confusing and it’s worth the time and money you’ll save to contact a professional to assist you in tax preparation services.
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