How Effective Tax Rate Is Calculated from Income Statements

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Every flourishing nation’s economy thrives using resources garnered through several sources of internal revenue. One of these is tax. Tax payable is obtained from both individuals, small businesses, and large corporations. It doesn’t matter the industry; as long as the individual or business is registered on the government’s database, you will be liable to pay tax returns on all your income.  

Tax, however, is deducted from virtually every event that has monetary significance, assets, and other unique identifiers. The amount paid by an individual, business, or corporation is known as the tax rate. In turn, the tax rate indicates a specific percentage of the total income of the individual or corporation. The money deducted is recorded as tax. There are numerous types of taxes that are payable, such as: 

  • Federal income tax 
  • Sales tax 
  • State income tax 
  • Local income tax 
  • Property taxes 

All these are deducted at various levels of business operation. There are specific distinguishing elements used to identify which type of tax is deducted from specific business dealings. However, when the deductions are made, in general, they are calculated as the effective tax rate. This is the general metric that is used to define two or more entities paying taxes. It accounts for the total tax payable by the entity irrespective of whether paying to the federal, state, or local government. It covers taxes in real estate as well. 

Tax rate calculation 

Focusing on the prime cause of changes in the income tax and its calculation, the most important thing to note is the income statements and the prevalent rate of taxation. A standard income statement measures a business or corporation’s performance across distinct periods, whether it is quarterly or annually.  

Some of the elements to consider in analyzing an income statement are: 

  • amount of sales 
  • operating income  
  • gross margin 
  • operating expenses 
  • net income 
  • tax expense 
  • dividend expenses, etc. 

These are the significant determinants of a company’s official financial status that educates the IRS about how profitable a business is. 

The company’s effective tax rate can thus be determined using the above-listed items peradventure included in the company’s financial statement. If one or two elements are missing, we would be unable to accurately measure the true gravity of the company’s activities. 

What the financial statement enables regulatory bodies to do is to evaluate the company’s earned income. Once it has been determined, the next step is to divide the income tax expense by the total income. 

Mathematically, imagine a company earns about $500,000 as of the net or total income but pays about $75,000. The tax rate would be $75,000/$500,000, which yields about 0.15. This means an income tax of about 15% is applied on the total income generated by the company. The rate of tax estimated also determines the degree of profitability of a company. This tax rate is known as the effective tax rate, which is individual or company-specific. 

Marginal tax 

Another type of income tax is the marginal tax rate. This is not company-specific; instead, it categorizes companies or individuals according to the tax bracket in which they fall. The tax rate tends to increase with an increase in income. It is also known as the progressive income tax system. This way, two companies or individuals earning the same income may not pay the same amount of tax.  

The bottom line in both types of taxes is that while two entities may pay the same effective tax rates their marginal tax rate differs. If they fall inside the same rank of marginal tax, their effective tax rate may also differ once income rises to an extent. Tax tends to build up over a financial calendar and there are several ways which are available to companies and high net worth individuals can pay taxes. One of the most prominent is via IRS in compromise. It works by enabling the individual or company to pay tax in kind by ceding a piece of asset. This way, a certain portion of the due tax is removed those reducing the tax burden. 

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By Fahim Hasan

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