Tax Accounting: Definition, Types, vs. Financial Accounting

What Is Tax Accounting?

Tax accounting is a structure of accounting methods focused on taxes rather than the appearance of public financial statements. In short, tax accounting is the means of accounting for tax purposes.

Tax accounting is governed by the Internal Revenue Code, which dictates the specific rules that companies and individuals must follow when preparing their tax returns. Tax accounting 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. The IRS also requires the use of specific documents and forms to properly submit tax information as required by law.

Types of Tax Accounting

Tax Accounting for Individuals

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 Businesses

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 Tax-Exempt Organizations

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.

The Bottom Line

Tax accounting is a set of methods for accounting and a useful tool that companies use to understand their tax liability and avoid penalties. Tax accounting is key not only for businesses but also for individuals to declare the correct income, pay appropriate taxes, and avoid penalties or IRS audits.