What Is a Tax Shield?
A tax shield is a reduction in taxable income by taking allowable deductions. Stated another way, it’s when a business or individual deliberately uses taxable expenses to offset taxable income.
Examples of Tax Shields
Tax shields involve investments and purchases that are tax deductible. Some common examples include charitable giving, mortgages, and depreciation expenses.
Charitable Giving
Charitable giving is a deductible expense for both individuals and businesses, with some restrictions and limits. For an individual to take a tax deduction on charitable giving, they must itemize deductions. Corporations can include charitable donations with some limits and restrictions.
Mortgages
A mortgage is a classic tax shield for both individuals and businesses. Note that it’s not the amount of the mortgage payment that’s deductible; it’s the interest expense.
Depreciation
Businesses can take a depreciation expense for buying business property, including equipment, furniture and fixtures, and vehicles (but not land). Depreciation is basically a way to spread out the expense of buying a business asset over the life of that asset. Accelerated depreciation allows you to depreciate more of the asset in the first year or two, and it’s a great example of a tax shield. The two types of accelerated depreciation are Section 179 expenses and bonus depreciation.
How Does a Tax Shield Save on Taxes?
Tax shields are part of an overall financial strategy. Look at it this way: As a person or a business, you can get tax deductions for certain types of purchases and activities. You can do this by accident, buying whatever you want whenever you want. Or you can save on taxes deliberately by planning purchases to take advantage of tax shields. For example, a business is deciding whether to lease a building or buy the building. Taking on a mortgage for the purchase of a building would create a tax shield because mortgage interest is deductible to a business. If the business puts the tax shield benefit from the mortgage into the decision, the tax benefit of a mortgage might make the decision easier.
What Are the Benefits of Tax Shields?
Tax shields are part of the overall financial strategy of businesses. Tax shields do the following:
Increase expenses, though they lower taxable income.Decrease cash on hand, but they put money into investments that provide a higher return.
Calculating the Value of a Tax Shield
The value of tax shields depends on the following:
Your business’s effective tax rateThe amount of the deduction
For example, if you expect interest on a mortgage to be $1,200 for the year, and your tax rate is 20%, the amount of the tax shield would be $240. As you review tax shields, compare the value of tax shields from one year to the next. 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.
How Does the Tax Cuts and Jobs Act Affect Tax Shields?
The Tax Cuts and Jobs Act has several effects on tax shields. The main change is the reduction in income tax rates, beginning with 2018 taxes. The corporate tax rate has been reduced to a flat 21%, starting in 2018, and personal tax rates have also been reduced. Another big change is that the standard deduction on personal tax returns has been doubled, decreasing the value of some tax shields, like mortgage interest and charitable giving. Taxpayers won’t be able to take advantage of these tax shields until they reach a level of deductions over the standard amount.
How to Take Advantage of Tax Shields
The best way to maximize the tax-saving benefits of tax shields is to take the tax shield factors into consideration in all business financial decisions. Of course, tax savings shouldn’t be the only consideration when you are planning your tax strategy for the year, but leaving tax shields out of the planning process can lower the value of your business and leave money on the table, so to speak.
