The lowdown on tax liability
Tax Liability comes down to your taxable income. The amount of business tax liability owed is based on the profits of your business and depends exponentially on the structure of your business. If your business is a sole proprietorship, single or multi-member limited liability company, or partnership, your tax liability will be based on pass-through taxation - this is also partly true for an S Corporation. If your business is C-Corporation, profits will be taxed at the corporate and state tax rate.
Your gross taxable income minus your tax deductions equals your gross tax liability. Gross tax liability minus any tax credits equals your total income tax liability.
Jumping in head first…
The first step to calculating your Total Tax Liability is to first get your Gross Tax Liability. You get your gross profit by subtracting the cost of goods sold (COGS) from revenue (sales from goods or services)*. You can typically find the gross profit in the first section of your profit and loss statement.
*you may also have to subtract allowances and discounts on your profit and loss statement.
Now that we have your gross profit, we can move on to calculate our total tax liability. Your total tax liability is your gross profit - deductions - any credits or adjustments.
| Understanding your tax liability is an important part of running your business. Take time to break down the numbers now to avoid headaches later.
Steps to final formula
- Calculate your total gross income.
- Sum totals of gross taxable income from all sources.
- Subtract your qualified business expenses from your gross taxable income.
- Subtract credits and adjustments from taxable income.
Gross Tax Liability: Taxable Income - Tax Deductions = Gross (Taxable) Income
Total Tax Liability: Gross (Taxable) Income - Tax Credits = Total Income Tax Liability.
I’ll lay out an example just to make sure this formula lands home.
Example: Clark owns Clark Beauty Essentials LLC“Clark.” Clark’s is based online and sells goods. When calculating Clark’s tax liability, the accountant will put their Profit and Loss Statement (“P&L”) after completing an audit of their books. Clark’s accountant reported the following from their P&L:
Discounts and Allowances: $5,000
First, we will solve for Gross Tax Liability
$95,000 - $5,000 - $28,000 = $62,000
Since the business is a Single Member Limited Liability Company, Clark’s profit will flow through to their tax return. Considering that Clark’s exemption status is single and this is Clark’s only income, we subtract the standard deduction amount from the gross income.
$62,000 - $12550 = $49,450
After taking the standard deduction, your tax is calculated, but you still have one more step to take, you must subtract any credits.
Next, we apply credits to a business and also individual credits if available.
Clark does not have any individual credits available, but his business did take advantage of the Work Opportunity Credit (“WOTC”). Clark received a WOTC in the amount of $2,400. After applying this credit to Clark’s gross tax liability, it is found that Clark has a Total Tax Liability of $4,227. This is the amount that Clark will owe.
The effective tax rate of $49,450 is 13.4%, making the tax liability $6,627. After getting the initial tax owed we must subtract any credits from this amount. Based on the problem, we will subtract $2,400 due to the WOTC.
$6,627 - $2,400 = $4,227
*calculation is based on the standard deduction in 2021 of $12,550
Why we didn't talk about adjusted gross income
Adjusted gross income (AGI) is a term used only for individuals, not for businesses. Adjusted gross income (AGI) is defined as gross income minus adjustments to income. It is equal to the total income subject to income tax, such as earnings from your job, self-employment, dividends, etc., — minus qualifying deductions and adjustments. For a business, this happens between steps 2 and step 3 above.
Disclaimer: While this article focuses on sole proprietors and single-member limited liability companies, each taxpayer’s situation is unique. This is just the basic math on how to calculate tax liability. This calculation does not take into account your specific circumstance or exemptions or any additional outside income. This is just a simple illustration of a tax liability calculation. You should contact an accountant regarding your specific tax circumstances.
Understanding your liability is only half the battle
Once you’ve calculated your tax liability, you’ll be expected to pay what you owe. To be sure you don’t increase your bill any further with fines and penalties for late fees, you’ll want to be sure these payments are on-time. Fortunately, tools like ComplYant can help you prepare for your business taxes, so you never miss a deadline.
Check out the other resources to read more about what factors can affect a business’s tax liability or how you can reduce your tax bill with deductions. Also, if you’d like to know more about preparing and even saving money during your year-end tax filing, check out the webinar 5 Year-End Tax Strategies for Small Business Owners.