Net of TaxExplained & Defined
What is Net of Tax?
Net of Tax is the remaining amount after deducting the applicable tax payments from the gross income.
Taxes are imposed on business and even investment transactions.
Another term for a net of tax is income after-tax and purchasing power.
How Does Net of Tax Work?
Both income and investments are subject to tax and every presentation of both amounts in the financial statement reports should be net of tax.
Different tax types apply to how income is generated:
- Ordinary or earned income. The generated income came from the business’s day-to-day operations/primary activities.
- Capital gains. It does not form part of the company’s primary business operation. These are non-operating income, like selling a piece of old equipment, land, shares, etc.
For example, a freelancer who earns $47,000 monthly should pay the corresponding income tax for self-employed individuals.
The same is not subject to other kinds of taxes like withholding taxes because such tax is only for employed individuals.
How is Net of Tax Calculated?
The computation of tax dues from ordinary income differs from capital gains.
For business income (income earned from the ordinary course of business), the amount taxable is the net profit.
The formula to arrive at the net profit is to deduct relative expenses from the net sales.
In the example above, the freelancer earned $47,000.
The net tax amount shall be calculated by deducting the income tax together with other self-employment tax deductions like social security contributions or medicare.
For this income level and the filing status of the taxpayer, the tax rate is set at 25%.
Assuming there the self-employment tax deductions are left out, the net of tax amount is, therefore, $35,250 ($47,000 – ($47,000 x 25%))
How Does Net of Tax Work for Capital Gains?
The component of capital gains tax calculations are:
- Basis (cost) of the asset. The original price and the selling price at the time of sale.
- Holding period of the asset. Long-term – held for more than a year. Short-term – held for less than a year.
- Tax rates. 15% – taxable income of $78,750 or more. 20% – subject to income limits and on your filing status if single, married, etc.
Other tax rates are imposed on real estate, stocks, bonds, etc.
For example, you bought shares of stocks a year ago for $180,000 and have decided to sell them now for $200,000, resulting in capital gains of $20,000.
Assuming the capital gains tax is 24%, the net of tax amount is $15,200 ($20,000 – ($20,000 x 24%)).
How Does Net of Tax Work for the Sale of a Business?
Selling the entire business might be a complex transaction from a tax point of view because every asset account has different treatment in terms of tax computation like land, buildings, machinery, etc., depending on the capital gains.
There are different strategies to lower the tax dues to every sale.
The seller company may decide to spread the sale across several years to recognize lower tax dues from capital gains.
The lower the sale price and the taxable income, the lower the tax dues.
A tax professional may help you to legally lower tax payments and it is advisable to include the net of tax discussions before selling.
Net of Tax vs. Net Income
Net of tax is widely used in the sale of long-term assets like land, buildings, equipment, etc.
It applies to individuals and even to business enterprises. Net income is the residual amount after deducting related expenses and tax payments from the gross income.
Importance of Computing the Net of Tax
The benefit of understanding the tax calculation is to give a more accurate interpretation of when will be the right time to sell an asset.
What will be the tax implication if the company sells the asset this year or in the coming years?
There are different ways to reduce tax payments legally.
The net of tax calculation may be a big help in such cases.
For example, if you are planning to sell an asset but you don’t know which asset would produce lower tax due, understanding the net of tax calculation can help sellers decide which sale transaction can result from much lower tax dues.
Both individuals and business enterprises use the net of tax calculation as a planning tool for a legal tax payment reduction, and it is best to consult with a tax professional for a better understanding of the advantages and disadvantages of every selling decision.
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Cornell Law School "net income tax" Page 1 . August 24, 2022