Tag Archives | income taxes

Prepaid Income Tax

See Also:
Marginal Tax Rate
Tax Brackets
Flat Tax Rates
Cash Flow After Tax
Unclaimed Property

Prepaid Income Tax Definition

In accounting, prepaid income tax is defined as an asset listed on the balance sheet that represents taxes that have been already paid despite not yet having been incurred. Prepaid income tax is also called a deferred income tax asset.

Prepaid Income Tax Explanation

Prepaid income tax is a form of prepaid expense. The most common reason why prepayment on income taxes occurs is due to over-estimation of tax deposits. In this situation, taxes are estimated from the financial records of the previous year. These estimated taxes are paid. Then, when the year-end taxes are found to be less than the taxes paid earlier, prepayment on income taxes has occurred. This prepayment can create one of two results: a tax refund or the credit written off towards the tax liability of the next period.

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The difference between prepaid income tax and a deferred tax asset is that prepaid income tax occurs within one year. On the other hand, a deferred income tax asset can occur for a period of longer than one year.

Prepaid income taxes are often the result of poor assumptions. Generally, company controllers overestimate the needed tax deposits. This is one of the most common cases leading to prepaid income taxes.

Prepaid Income Tax Journal Entry

The following is what the prepaid income tax journal entry may look like:

DR                                                    CR
Prepaid Income Tax               $100,000
Cash                                                                                              $100,000

Income Tax Expense              $25,000
Prepaid Income Tax                                                                   $25,000

Result: Prepaid income tax balance = $75,000
 

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Whole New Meaning For “Tax Return”

I was helping my daughter prepare her tax return last night. She graduated in May of 2009 and started a job in August 2009. As she was entering information into Turbo Tax she asked me how much money she would get back. I informed her that she may or may not get any money back. In fact, some years she might have to write a check!

She was shocked! She said, “I thought tax returns meant that they return your taxes!”

Once I stopped laughing, I spent the next 30 minutes explaining the difference between getting a refund and how much taxes you pay. Needless to say it was an awakening for her.

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History of Income Tax Rates: Refresher

After the President’s recent State of the Union speech it might be a good time to refresh our knowledge of income tax rates in history. Given the massive deficit that the government is creating it is inevitable that income tax rates will go up. But by how much? History should provide a clue as to how high they can go.

Question: How long ago was the marginal income tax rate double today’s rate of 35%? Answer: 29 years ago or 1981!

Question: What is the highest marginal tax rate in history? Answer: 94% in 1945!

Question: What was the beginning marginal tax rate in what year? Answer: 7% in 1913 for incomes over $500k!

Income taxes have been in existence for almost 100 years in the United States. They are presently the lowest they have been during that time period. What are the chances of them staying this low in the future?

During this 100 year period the taxable income threshold has dropped after being adjusted for inflation. Furthermore, income taxes have increased or taxable income thresholds have dropped after every major war time period. In other words, the government has had to pay for WWI, WWII, Korean and Vietnam Wars with higher taxes. We now have two wars to pay for; Afghanistan & Iraq!

The question faces us in not whether income taxes will increase but how high will they go? It is entirely possible that the marginal tax rates could go back up to a 70% bracket in the next 5 years.

For the past 25 years we have tended to ignore the tax effect of Federal income taxes on our investments. Going forward taxes will have a bigger impact on the economics of our deals. In the future business is going to be buffeted by strong headwinds: higher taxes and higher interest rates!

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When will it end?

Thanks to an incredible increase in the leverage used by various commercial banks, investment banks, and investment firms over the last 6 years, the US capital markets and perhaps the world’s teeter on the verge of collapse. For a good overview and one that puts it in the proper perspective, see this from the WSJ.

This has led the US government to make a $85 billion direct equity investment in AIG, receiving 80% of AIG’s equity. For a critical reaction, see here.

The Fed is also continuing to print money to increase liquidity available to banking institutions.

In recent days, we’ve seen the federal government take the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) into conservatorship, confirming the GSE status that many in the nation’s capital seemed to misunderstand or not understand at all. There was also the loan guarantee the Fed provided to JPMorgan Chase to acquire a faltering Bear Stearns. Amazingly, at least one significant financial market player (Lehman Brothers) was actually allowed to fail.

Lest we forget that Detroit is likely to be heading to DC with hat in hand sometime soon.

These are interesting times, to say the least. And to top it off, we have a presidential campaign nearing its conclusion in less than 50 days, with both campaigns offering some version of increased federal government involvement in the economy, and in particular in the capital markets.

How this plays out is far from certain, but it seems a near certainty that the taxpayers across the fruited plain will be left holding the bag.

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Don’t Let Tax Strategies Drive Financial Performance

With most young companies cash is king. As a company grows managing the cash available to finance that grow is crucial to sustaining the growth rate. Minimizing the cash expenses of the company is an entrepreneurs and CFO’s primary job. One of the main cash expenses is federal income taxes.

During this start up and growth phase (which can last 10years or more) the entrepreneur is focused on minimizing the cash payments for federal income taxes. He will work closely with his tax CPA to aggressively take financial positions that minimize taxes.

Somewhere along the line this strategy begins to lose its effectiveness. It generally happens when outside bank financing is obtained to fuel the growth of the company. As larger and larger amounts of outside debt is obtained the financial reporting needs of the company changes. The financial statements must now be presented to new users (i.e. the bank). The banks are seeking a clearing picture of the financial position of the company on an accrual basis. Often they want to know the true equity available from the company so they can establish the leverage of the company.

But maximizing the equity value of the company often is at odds with minimizing federal income taxes. To minimize taxes you typically end up either taking deductions sooner, deferring the recognition of income or valuing assets more conservatively. Taking these positions is fine until you want to borrow money.

Most entrepreneurs want to borrow as much as they can to fuel growth. However, by presenting there financial statements on a tax basis they minimize the amount that lenders will advance.

The answer is that just as no strategy works in every situation, neither does one strategy work forever. The goal of the CFO should be to educate the owner to the needs of the other users of the financial statements. Often the benefits of paying higher income taxes is offset by the increased growth rate of the company.

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