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Income tax provision, explained

The income tax expense in your financial statements: tax owed for this year, plus the future tax effect of differences between your books and your tax return.

Section
US GAAP
Mentioned in
3 pages
Illustration only. No real figures.

What it means

ASC 740 covers how income taxes show up in your financial statements. The result is called the income tax provision: the tax expense on the P&L, plus related balances on the balance sheet. It's separate from the tax return, which is what you file with the IRS and the states.

The provision has two parts. Current tax is what this year's returns will show as owed. Deferred tax is the future effect of differences between your books and your return, including losses you can carry forward against future profits.

A company that loses money builds up net operating losses, or NOLs. Because they can reduce tax in a future profitable year, GAAP records them as a deferred tax asset. It then asks whether it's more likely than not, meaning a better than even chance, that the asset will be used. Without a history of profits the answer is usually no, so a valuation allowance offsets it in full.

Current tax is often small but rarely zero. State minimum taxes and franchise taxes based on income can still apply, and they belong in the provision.

Acme's losses carried forward and other book-to-tax differences produce a $210,000 deferred tax asset. With no record of profits, it isn't more likely than not to be used, so Acme records a $210,000 valuation allowance. The two net to zero, so the balance sheet shows no tax benefit and tax expense is whatever state tax Acme owes for the year.

Usually at year end, for your first audit. Section 174 and capitalized software are common sources of book-to-tax differences, and the Form 1120 is the return the provision is reconciled to.

Why it matters. Your first audit will ask for it. For a loss-making startup the answer is usually a deferred tax asset from losses, offset by a full valuation allowance, plus any state minimums.

Try it with your numbers

Change any number. The working below updates as you type.

A federal tax provision, current and deferredTax expense = Current tax + (Opening − Closing net deferred tax asset) · Deferred tax = 21% × (NOL + Temporary differences) − Allowance
$

Negative for a loss.

$

Never reverse: 50% of business meals, fines.

$

Arising this year; positive when deducted on a later return.

$
$

Deductible differences still to reverse.

Full valuation allowance?

Federal income tax expense

$0.00

How it’s worked out

  1. 1Taxable income before the NOL($1,500,000.00) + $20,000.00 + $50,000.00($1,430,000.00)
  2. 2NOL usedLesser of $3,000,000.00 and 80% of taxable income$0.00
  3. 3Current tax21% × $0.00$0.00
  4. 4NOL carried forward$3,000,000.00 − $0.00 + $1,430,000.00 new$4,430,000.00
  5. 5Gross deferred tax asset, year end21% × ($4,430,000.00 + $50,000.00)$940,800.00
  6. 6Valuation allowanceFull allowance against the net asset($940,800.00)
  7. 7Deferred tax expense$0.00 opening − $0.00 closing$0.00
  8. 8Total tax expense$0.00 + $0.00$0.00
  9. 9Effective tax rate$0.00 ÷ ($1,500,000.00)0.0%

With a full valuation allowance the deferred tax asset nets to zero, which is the usual answer for a loss-making startup. Federal only at 21%: state taxes, credits, uncertain positions and pre-2018 losses are left out. A temporary difference here is positive when book expense is deducted on a later return, like accrued bonuses or reserves.

Formula fromWikipedia — Deferred tax26 U.S.C. §11(b) — 21 percent corporate rate (Cornell LII)26 U.S.C. §172(a) — 80 percent NOL limitation (Cornell LII)

The entry, worked

About $1,000,000 of losses carried forward and other book-to-tax differences, at the 21% federal rate, give Acme a $210,000 deferred tax asset. With no history of profits, it isn't more likely than not to be used. Shown net: the deferred tax benefit and the allowance expense cancel.

Recording a deferred tax asset with a full allowanceBalanced
AccountDebitCredit
Deferred tax asset$210,000.00
Valuation allowance$210,000.00
Total$210,000.00$210,000.00

The asset and the allowance net to zero, so the balance sheet shows no tax benefit and income tax expense is unchanged.

Common questions

Why would a company with losses have a deferred tax asset?

Losses carried forward can reduce future taxable income, which is a future tax benefit. GAAP records it, then reduces it with a valuation allowance if it's not more likely than not to be realized.

Does my tax preparer do the provision?

Often the same firm does both, but they're different work. The return is for the IRS; the provision is for your financial statements and your auditor.

Are my net operating losses guaranteed to be usable?

Federal losses from tax years beginning after 2017 carry forward indefinitely but can offset only 80% of taxable income in a later year. Section 382 can also cap how much a year you may use after an ownership change of more than 50 percentage points over three years, which a string of financing rounds can trigger.

Where it comes up

The glossary entries, founder guides and lessons on this site that use the term and link here.

Read further

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General information for US companies, not tax, legal or accounting advice. Check the specifics with a CPA before you act on them.