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Tax Basis of an Asset

Assets are expected to generate economic benefits for the firm when they are sold or used. The tax basis of an asset is the amount related to the asset that the Internal Revenue Code allows to be deducted from any revenues generated by the sale or use of the asset for income tax purposes. As a result, the tax basis reduces taxable income when the carrying amount of the asset is recovered. The tax basis is typically the cost of the asset. Since accountants generally recognize assets at historical cost on the books, the carrying cost of an asset and its tax basis are typically equal. For example, if I purchase merchandise inventory for $500 and sell it a month later, its tax basis and its carrying amount would both equal $500. That is, when I sell the inventory, I can expense $500 for both accounting purposes and tax purposes.

Nonetheless, differences between the carrying cost and the tax basis of an asset sometimes arise when income or expenses related to the asset are charged to accounting income but are not recognized for tax purposes, or vica versa. This commonly occurs for items such as depreciable assets and accounts receivable.

Tax Basis for Depreciable Assets

Depreciation under GAAP and the Internal Revenue Code is often different. For example, if a $20,00 truck is depreciated using the straight-line method and is expected to last 4 years, after one year it would be carried on the books at $15,000. However, the Internal Revenue Code might allow the company to depreciate 30% of the truck for tax purposes. At the end of one year the truck would have a tax-basis of $14,000.

If the truck were sold for $15,000, no accounting gain or loss would be recorded. However, a gain of $1,000 would be reported for tax purposes ($15,000 - $14,000). This might seem unfair, but its important to note that the difference arises because the company was able to expense an additional $1,000 of depreciation for tax purposes in the previous year than it was able to for accounting purposes.

Because the financial statements assume that assets will be recovered and settled at their carrying amounts, the difference between the assets carrying amount and tax basis must be recognized as either a deferred income tax asset or liability. In our example above, the carrying amount is $15,000 but there is a future income tax amount payable on $1,000 of that. If the income tax rate is 35%, a future tax liability of $350 should be recognized on the financial statements today (see Deferred Income Taxes).

Tax Basis for Accounts Receivable

When a sale is made on account, the revenue associated with the sale is reported in accounting income. However, revenue is not reported for tax purposes until it is actually received in cash. For example, if a company makes $5,000 worth of sales on account but is not expected to be collected until next period, the receivable would have a carrying amount of $5,000 but a tax basis of $0.

We know from above that a difference between the carrying amount and the tax basis of an asset should be recognized. If the tax rate is 35%, a future tax liability of $1,750 should be recognized on the financial statements today (see Deferred Income Taxes). 

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