What is income tax?

Income tax (definition)

Income tax is a government levy on the earnings of individuals and businesses. The collected money contributes to public services and infrastructure.

Individuals and businesses submit returns declaring their taxable income. Tax authorities can levy fines or other penalties if sole traders or businesses don’t comply with the tax rules.

Three types of income tax

The type of income tax you or your business pays depends on your situation.

Personal income tax

Individuals pay taxes on their personal income. These taxes are often progressive, meaning they increase as income rises.

Business income tax for sole traders and partnerships

Profits (or losses) from the business are combined with the owner’s other income and reported on their personal return. They pay personal income tax on the final amount.

Partnerships generally file a separate business tax return as well, which the tax office checks against the personal returns of the partners.

Business income tax for companies

Companies pay taxes on their net profits. These taxes are often at a ‘flat rate’, meaning the same tax rate applies no matter how big or small the profit may be. The dividends or salaries the company pays its owners are taxed as part of the recipient's personal income tax.

Income tax rates

As tax rates can change, it’s best to go to the official source:

How to calculate income tax

The basic formula to calculate income tax is:

Income tax = Taxable income x Tax rate

You may need to use several tax rates when calculating progressive income taxes – see the example below.

Example flat rate income tax calculation

A company with revenue of $240,000 and expenses of $140,000 is subject to flat rate tax of 20%.

Taxable income (revenue – expenses) x Tax rate

($240,000 – $140,000) x (20/100)

= 100,000 x 0.2

= 20,000

The company owes $20,000 of income tax.

If the company distributes after-tax profits to its owners, they’ll need to declare that income on their personal tax return as well.

Example progressive income tax calculation

An individual earns $70,000 in wages and makes $30,000 in profits from a sole trader business. The total income of $100,000 touches three tax brackets.

This person would pay:

  • 0% on the first $30,000
  • 33% on the next $50,000
  • 40% on the final $20,000

($30,000 x 0) +( $50,000 x 0.33) + ($20,000 x 0.4)

= 0 + 16,500 + 8,000

= 24,500

This individual owes $24,500 of income tax.

Reporting and paying business income tax

All forms of businesses pay income tax only on their net profit (before taxes). When lodging a return, businesses are expected to report revenue and expenses, and may be asked to provide copies of the corresponding invoices and receipts.

Businesses may also be asked to prepay taxes in instalments throughout the year to avoid big end-of-year bills. These instalment plans are often based on projected earnings or the previous year’s profits.

What info does a business need to calculate income tax?

  • Revenue and expenses, found on the income statement (also known as a P&L)
  • Depreciation claim for assets owned by the business
  • Tax credits, if applicable, which can be subtracted from the taxes owed

Software like Xero can simplify your income tax by capturing transaction data (including copies of invoices and receipts), automating depreciation calculations, and generating financial reports.

It’s a good idea to get support from a tax professional. You can find one in the Xero advisor directory.

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This glossary is for small business owners. The definitions are written with their requirements in mind. More detailed definitions can be found in accounting textbooks or from an accounting professional. Xero does not provide accounting, tax, business or legal advice.