When a taxable event occurs, tax liability is the money that needs to be paid to a local, state, and/or federal agency.
Taxes due are usually a percentage of the taxable event. When a business sells a product, state sales tax may be charged. The seller collects the tax and then reports it to the local and state government agencies on a regular basis, usually monthly or quarterly. The money is set aside until the tax is paid. This is considered a tax liability and is a legally binding debt.
For example, Nick’s Jewelry Shop sells necklaces, bracelets, and rings. The business charges 6% state sales tax on all items sold and pays tax to the state monthly. A necklace selling for $48.00 will generate a tax liability of $2.88. The money collected from every sale during the month, and this tax liability will need to be paid to the state by the required due date.
Earning income is considered a taxable event. In most situations, state and federal income tax payments are due based on a percentage of income generated. The Internal Revenue Service (IRS) uses federal tax brackets to determine income tax liability. Taxpayers with lower taxable income owe a lower percentage of tax liability than those in higher wage groups.
When businesses pay employees, wages are subject to payroll taxes. The business needs to withhold certain taxes and match other taxes. This payroll tax money is set aside, then paid to the state and federal tax departments. Paying the tax reduces or eliminates the liability.
Tax liabilities are considered short-term liabilities and are reported on a financial statement called a Balance Sheet.