Tax Accounting: Definition, Types, and the Difference Between Financial and Tax Accounting

What Is Tax Accounting?

Tax accounting is a set of accounting processes that is primarily concerned with taxes rather than the presentation of public financial statements. The Internal Revenue Code governs tax accounting, which specifies the specific procedures that businesses and individuals must follow while completing their tax returns.

KEY TAKEAWAYS

• Tax accounting is the subsector of accounting that deals with the preparations of tax returns and tax payments.

• Tax accounting is used by individuals, businesses, corporations and other entities.

• Tax accounting for an individual focuses on income, qualifying deductions, donations, and any investment gains or losses.

• For a business, tax accounting is more complex, with greater scrutiny regarding how funds are spent and what is or isn't taxable.

Understanding Tax Accounting

Tax accounting is the means of accounting for tax purposes. It applies to everyone—individuals, businesses, corporations, and other entities. Even those who are exempt from paying taxes must participate in tax accounting. The purpose of tax accounting is to be able to track funds (funds coming in as well as funds going out) associated with individuals and entities.

Tax Accounting Principles vs. Financial Accounting (GAAP)

In the United States, there are two sets of principles that are used when it comes to accounting. The first is tax accounting principles and the second is financial accounting, or generally accepted accounting principles (GAAP).

Under GAAP, companies must follow a common set of accounting principles, standards, and procedures when they compile their financial statements by accounting for any and all financial transactions. Balance sheet items can be accounted for differently when preparing financial statements and tax payables. For example, companies can prepare their financial statements implementing the first-in-first-out (FIFO) method to record their inventory for financial purposes, yet they can implement the last-in-first-out (LIFO) approach for tax purposes. The latter procedure reduces the current year's taxes payable.

While accounting encompasses all financial transactions to some degree, tax accounting focuses solely on those transactions that affect an entity's tax burden, and how those items relate to proper tax calculation and tax document preparation. Tax accounting is regulated by the Internal Revenue Service (IRS) to ensure that all associated tax laws are adhered to by tax accounting professionals and individual taxpayers.2 The IRS also requires the use of specific documents and forms to properly submit tax information as required by law.

Hiring a professional tax accountant is optional for an individual, but often necessary for a corporation, as business taxes are more complicated than personal taxes.

Types of Tax Accounting

Tax Accounting for an Individual

For an individual taxpayer, tax accounting focuses solely on items such as income, qualifying deductions, investment gains or losses, and other transactions that affect the individual’s tax burden. This limits the amount of information that is necessary for an individual to manage an annual tax return, and while a tax accountant can be used by an individual, it is not a legal requirement.

Meanwhile, general accounting would involve the tracking of all funds coming in and out of the persons' possession regardless of the purpose, including personal expenses that have no tax implications.

Tax Accounting for a Business

From a business perspective, more information must be analyzed as part of the tax accounting process. While the company’s earnings, or incoming funds, must be tracked just as they are for the individual, there is an additional level of complexity regarding any outgoing funds directed towards certain business obligations. This can include funds directed towards specific business expenses as well as funds directed towards shareholders.

While it is also not required that a business use a tax accountant to perform these duties, it is fairly common in larger organizations due to the complexity of the records involved.

Tax Accounting for a Tax-Exempt Organization

Even in instances where an organization is tax-exempt, tax accounting is necessary. This is due to the fact that most organizations must file annual returns. They must provide information regarding any incoming funds, such as grants or donations, as well as how the funds are used during the organization’s operation. This helps ensure that the organization adheres to all laws and regulations governing the proper operation of a tax-exempt entity.

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