Tax Shield: Definition, Formula for Calculation, and Example

The two types of accelerated depreciation are Section 179 expenses and bonus depreciation. Let’s say a business decides to take on a mortgage loan on a building instead of leasing the space because mortgage interest is tax deductible, thus serving as a tax shield. As a result, the gross income for the business would be reduced by the amount of interest paid on the mortgage, thus, reducing its taxable income. Using illegal methods to avoid tax payment is known as tax evasion. The interest tax shield has to do with the tax savings you can receive from deducting various interest expenses on debt.

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The benefit of using depreciation with a tax shield is that you can subtract any depreciation expenses from taxable income. These intangible assets can affect your rate of tax accountability vs responsibility and tax expense. There are many examples of a tax shield, and it often depends on the tax rate of the corporation or individual as well as their tax-deductible expenses.

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Businesses looking to cut expenses may consider a tax shield as a way to lower their taxable income. Choosing the right tax shield takes some planning, and may require you to talk with a tax professional. A tax shield is a fully legal strategy that taxpayers can use to reduce their tax burden and should not be confused with tax evasion. Tax evasion, also known as tax fraud, is the illegal and intentional failure to pay the full tax balance owed to the U.S. government. Itemized deductions allow you to deduct the dollar amount of various expenses, such as interest on student loans and mortgages. If your total allowed deductions are higher than your standard deduction, you might be better off itemizing, meaning you wouldn’t take the standard deduction.

Tax Shield vs. Tax Evasion

It can also depend on the type of taxable expenses being used as a tax shield. A Tax Shield is an allowable deduction from taxable income that results in a reduction of taxes owed. Tax shields differ between countries and are based on what deductions are eligible versus ineligible. The value of these shields depends on the effective tax rate for the corporation or individual (being subject to a higher rate increases the value of the deductions).

Both individuals and corporations are eligible to use a tax shield to reduce their taxable income. This happens through claiming deductions such as medical expenses, mortgage interest, charitable donations, depreciation, and amortization. Taxpayers can either reduce their taxable income for a specific year or choose to defer their income taxes to some point in the future. These deductions reduce a taxpayer’s taxable income for a given year or defer income taxes into future years. Tax shields lower the overall amount of taxes owed by an individual taxpayer or a business.

• A tax shield is a financial strategy that allows businesses or individuals to reduce their taxable income, resulting in a lower tax liability.
• This then means that the businesses will be able to a great value of money.
• If your business has a higher income and a higher tax rate in one year, the amount of tax savings will be higher in that year.
• A tax shield refers to tax deductions that an individual or business can take to lower their taxable income.
• Their benefits depend upon the taxpayer’s overall tax rate and cash flow for the given tax year.

Over the ten-year period, the cumulative tax savings would amount to $15,000 ($1,500 annual tax savings multiplied by ten years). This means the business would have saved $15,000 in taxes due to the depreciation tax shield. Let’s consider a practical example to see how a tax shield works in real life. Imagine a small business that invests in machinery for production purposes.

It also provides incentives to those interested in purchasing a home by providing a specific tax benefit to the borrower. It should be noted that regardless of what depreciation method is used the total expense will be the same over the life of the asset. Thus, the benefit comes from the time value of money and pushing tax expenses out as far as possible.

A tax shield will allow a taxpayer to reduce their taxable income or defer their income taxes to a time in the future. To calculate a tax shield, you need to know the value of your tax-deductible expenses and your own individual tax rate. A tax shield is a legal way for individual taxpayers and corporations to try and reduce their taxable income. The total value of a tax shield is going to depend on the tax rate of an individual or corporation and their tax-deductible expenses. The tax shield is a very important aspect of corporate accounting since it is the amount a company can save on income tax payments by using various deductible expenses. The higher the savings from the tax shield, the higher the company’s cash profit.

The reason that he was able to earn additional income is because the cost of debt (i.e. 8% interest rate) is less than the return earned on the investment (i.e. 10%). The 2% difference makes income of $80 and another $100 is made by the return on equity capital. Total income becomes $180 which becomes taxable at 20%, leading to the net income of $144.