Net of tax is the amount obtained after the applicable tax is deducted from the gross income that resulted from investments or transactions. Net of tax is a term most commonly used for showing the results of businesses in terms of income, profits, or losses. If the tax effect is considered in the calculation of the income, profit, or loss, then these are described to be “net of tax.”
The income, profit, or loss is said to be “before tax” if the income tax effect is not considered in the calculation. Net of tax is also known as after-tax.
Net of tax is the resultant amount when taxes are deducted from the gross income from a financial transaction.
The net of tax calculation depends on the type of income.
The analysis of the net of tax provides various ways to lower taxes. It also helps to decide which investments are offering lower taxes and are worth selling.
Net of Tax Formula
For example, assume a company earns a gross income of $250,000 in 2019 and is liable to pay corporate tax at a 35% rate. Therefore, the net income of the company after paying taxes will be:
Gross income = $250,000
Corporate tax rate = 35%
Tax payable on gross income = $250,000 * 35% = $87,500
Net income after tax = $250,000 – $87,500 = $162,500
It is important to note that a company can neither keep the gross income as its retained earnings nor use it for paying out dividends. The company can only declare dividends on income net of tax and only keep the net income as retained earnings due to its obligation to pay corporate taxes.
An organization deemed as a not-for-profit is not required to pay income taxes; hence, such an organization does not use the concept of the net of tax in financial reporting. For not-for-profit organizations, the gross income and net income will be the same.
Types of Income and Net of Tax
1. Ordinary income
Ordinary income is derived from business activities such as sales of products. It is also called earned income. For businesses, the net income or profit is the ordinary income that is subjected to tax. Taxes due on the ordinary income are deducted to obtain a net of tax income.
2. Capital gains
Capital gains are the income obtained from the sale of investments or assets related to business – even the complete business. The capital gain amount depends on the cost of the asset and its worth at the time of sale.
The tax rate on capital gains depends on the type of asset and the duration for which the asset has been held. Capital gains taxes vary depending on the type of assets.
Moreover, capital gains tax rates also vary depending on the holding period for the asset. The longer the asset has been held, the lower the capital gain tax rate will be.
Importance of Net of Tax Calculation
Considering the sale of assets or the entire business in the current year or next year, the net of tax calculation for both years can show the effect of lower tax and help in deciding which year to conduct the sale.
It allows us to evaluate different investments in terms of the least possible tax to be paid while selling the investment. The net amount on a transaction helps in deciding which investments to sell and at what time.
It can also be used as a tax planning tool and can help in examining various ways to lower taxes.
It affects investment strategies and financial planning. For example, an investor can hold an asset for longer periods to pay lower capital gain taxes.
It can be used to determine the true proceeds of a financial transaction. The net of tax amount shows how much the sellers have earned against what they have expected.