What Is Tax Accounting?

What Is Tax Accounting?

Let me explain tax accounting directly: it's the accounting method you use to prepare tax returns for yourself, your business, or any other entity. It's all governed by the Internal Revenue Code, and it tracks money coming in and going out, but only the parts that impact taxes. Unlike financial accounting, which looks at everything, tax accounting zeros in on tax-related transactions.

Key Takeaways

You should know that tax accounting is a specific branch of accounting dedicated to preparing tax returns and handling tax payments. It's applicable to individuals, businesses, corporations, and other entities. For individuals, it emphasizes income, qualifying deductions, donations, and any gains or losses from investments. When it comes to businesses, tax accounting gets more intricate, with closer examination of how funds are spent and what's taxable or not.

Tax Accounting Principles vs. Financial Accounting (GAAP)

In the United States, you have two main sets of accounting principles: those for taxes and those for financial reporting, known as generally accepted accounting principles or GAAP. Under GAAP, companies follow a standard set of rules when putting together their financial statements, accounting for every financial transaction. But items on the balance sheet can be handled differently for financial statements versus tax purposes. For instance, a company might use the first-in-first-out (FIFO) method for inventory in financial reports, but switch to last-in-first-out (LIFO) for taxes to lower the current year's tax bill.

Accounting in general covers all financial transactions to some extent, but tax accounting narrows it down to just those that influence your tax burden, including how they tie into accurate tax calculations and document preparation. The IRS regulates tax accounting to make sure professionals and taxpayers follow all relevant tax laws. They also mandate specific forms and documents for submitting tax information as required by law.

Important Note on Hiring Professionals

Hiring a professional tax accountant is optional if you're an individual, but for corporations, it's often necessary because business taxes are far more complicated than personal ones.

Tax Accounting for Individuals

If you're an individual taxpayer, tax accounting concentrates only on things like your income, qualifying deductions, investment gains or losses, and other transactions that affect your tax burden. This keeps the information you need to manage your annual tax return straightforward, and while you can hire a tax accountant, it's not legally required. In contrast, general accounting would track all your incoming and outgoing funds, including personal expenses that don't impact taxes at all.

Tax Accounting for Businesses

From a business standpoint, tax accounting requires analyzing more information. You have to track the company's earnings or incoming funds just like for individuals, but there's added complexity with outgoing funds for business obligations, such as specific expenses or payments to shareholders. It's not mandatory for a business to use a tax accountant, but in larger organizations, it's common due to the intricate records involved.

Tax Accounting for Tax-Exempt Organizations

Even if an organization is tax-exempt, tax accounting is still required. Most such organizations must file annual returns, providing details on incoming funds like grants or donations, and how those funds are used in operations. This ensures they comply with all laws and regulations for tax-exempt entities.

What Is the Main Purpose of Tax Accounting?

The primary purpose of tax accounting is to perform accurate tax calculations and prepare the necessary documents in time for filing season.

What Is the Difference Between a Tax Accountant and a Management Accountant?

A management accountant works internally for their own company and can't handle external clients, whereas a tax accountant is an external professional who can work with various businesses and individuals. Management accountants help their companies understand the financial impacts of decisions and offer strategic advice. Tax accountants, on the other hand, assist companies and individuals in meeting taxation requirements.

How Can You Start a Career in Tax Accounting?

To become a tax accountant, you need Certified Public Accountant (CPA) licensure, which typically requires a bachelor's degree in accounting or a related field. While not mandatory, consider pursuing a master's in accounting as a CPA candidate. Tax accountants also need to complete continuing education courses to keep their credentials, with requirements varying by state.

The Bottom Line

Tax accounting consists of methods for accounting that help companies figure out their tax liability and avoid penalties. It's essential not just for businesses but also for individuals to report the right income, pay the appropriate taxes, and steer clear of penalties or IRS audits.