What Is a Tax Provision and How Can You Calculate It?

A tax provision safeguards your business from paying penalties and interest on late taxes. It’s an estimation of your current year’s tax liability that’s set aside until the payment comes due. The tax provision process is a crucial part of financial planning for businesses.

Tax provisions are only one kind of provision. Depending on the industry, a business might also create provisions for bad debts, depreciation, pensions, sales allowances, and more.

In this article, we’ll focus on tax provisions, why they’re important, and how to calculate them.

What is a tax provision?

A tax provision is the estimated amount your business is expected to pay in state and federal taxes for the current year. While a provision is a financial burden, it also offers important protections. You’ll want as precise an estimate as possible for your provisions but may also want to set aside a small buffer amount to account for any uncertain tax positions.

The amount to set aside as an income tax provision is derived by estimating your company’s gross income for the year and the applicable tax rates. These are multiplied to arrive at an estimate, which is usually rounded to a viable figure. Here’s what the calculation for this looks like:

1. Estimate net income for the year.
2. Consider applicable tax rates. (We recommend consulting an accountant for this. Tax brackets can be more confusing than you’d think.)
3. Multiply the two.
4. Add a small buffer.

Income tax provision = (Net [taxable] income before taxes) x (Applicable tax rates) + Buffer

If that seems simple enough, read on because things can get slightly more complicated!

How can you calculate a tax provision?

Accurately determining the exact amount of income tax owed can be time-consuming. So, consider letting tax professionals handle your accounting while you focus on growing your business.

Still, it’s a good idea to at least have a working knowledge of provisions when you’re running a business. We’ll break down the calculation of corporate tax provisions under Accounting Standards Codification (ASC) 740. The ASC 740 lays out how companies should recognize income tax on their financial statements.

The two main aspects of a tax provision

Calculating tax provisions is complicated because of the differences between U.S. Generally Accepted Accounting Principles (GAAP) procedures and the income tax accounting rules. Most accounting departments follow U.S. GAAP guidelines, which results in a difference between their estimates and the actual income tax owed.

Before we look more deeply at the calculation, we should first look at the two parts of calculating tax provision.

Current year income tax expense

The current income tax expense refers to the net amount a company owes to the IRS. It accounts for the current earnings and the permanent and temporary tax differences when calculated using GAAP versus the amount the IRS will calculate.

Here’s how to calculate the current income tax provision:

1. Estimate your company’s net income for the financial year. This refers to the company’s net taxable income for the year. GAAP rules direct accountants on how to calculate a company’s net annual income for tax provisions.
2. Calculate the permanent differences. There are expenses that should be included in your calculations according to the GAAP but aren’t allowed for tax purposes. This difference in calculations leads to a discrepancy in the final results that needs to be accounted for.

These differences are never reversed, and since you can’t register these expenses for income tax purposes, they’re considered permanent. Common examples include penalties, fines, municipal bond interest, and life insurance proceeds.

3. Calculate your temporary differences. These refer to expenses that can be accounted for in GAAP or for income tax purposes but not both in one year. You can calculate this by comparing the difference between the GAAP calculations of your company’s current year balance sheet and your income tax calculations.

These differences are eventually reversed, so they’re referred to as temporary. Common examples include depreciation and expenses that were incurred but not yet paid.

4. Apply your tax credits and account for net operating losses (NOL). Tax credits and NOL are deducted from the net taxable income. The amount you’re left with is the amount you actually pay taxes on. Some of these may be carryforwards from the prior year.
5. Apply the current tax rate. You can do this by multiplying your current year’s taxable income by the current federal corporate tax rate, which yields your company’s current tax expense for the income tax provision.

Income tax expense = taxable income x current tax rate
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Deferred income tax expense

The deferred income tax expense refers to a cost that’s noted as a liability on your balance sheet but doesn’t have to be paid just yet. Deferred income tax expense is the opposite of deferred tax assets. It’s also a result of the differences in income recognition between income tax accounting rules and your company’s accounting.

The deferred income tax expense calculates the sum total of the temporary differences and applies the federal corporate tax rate to the resulting amount. After this, the deferred tax expense must be accounted for on your GAAP balance sheet as an asset or a liability, depending on whether your company is due to receive a tax benefit or whether it will need to make a future tax payment.

How to enhance your tax provision calculation

It can be a lot easier and faster to calculate tax provisions with the right strategies.

Get the right data

Ensuring that the data you have consolidated is accurate and representative of your company’s transactions is crucial. This can be collected from your company’s financial statements, which should always be up to date.

Use a tax provision checklist

A tax provision checklist can help you tick off all the items you need to account for while calculating your estimated tax amount. Be sure to consider these three categories:

Use the right criteria

Make sure to check your calculations and verify that you’re using the correct criteria to calculate your tax payments. This includes considering tax-exempt income and calculating your effective tax rate (ETR).

Use tax provision software and automate your process

Tax provision calculations are often complicated and prone to errors. The strict filing deadlines and increasing complexity of tax laws only add to the challenge!

To eliminate the margin for human error, you might consider tax provision automation software like:

• Bloomberg Tax Provision
• ONESOURCE Tax Provision
• OneStream Tax Provision

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Prepare yourself for making a tax provision

Tax provisioning and financial reporting is a tricky process. Due to the complexity of the calculations, the smallest of errors can often snowball to create massive discrepancies. These can lead to improper filings, which can cost you in fines and interest fees and even subject you to correctional measures (in severe cases).

With Upwork, it’s simple, cost-effective, and fast to hire the best professionals anywhere, any time. We have a roster of independent financial accounting professionals who can help you with tax planning and ensure all of your calculations are accurate.

If you believe you’ve got what it takes to help others calculate their tax positions, it might be worth considering starting your own accounting business. If you decide to take the plunge, we have a number of accounting jobs on Upwork for you to browse.