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# Tax Shield – Definition

### Tax Shield Definition

A tax shield refers to an allowable deduction on taxable income, which leads to a reduction in taxes owed to the government. Such allowable deductions include mortgage interest, charitable donations, medical expenses, amortization, and depreciation. These deductions reduce the taxable income of an individual taxpayer or a corporation.

### A Little More on What is a Tax Shield

Tax paid by businesses is usually on the interest they generate. Therefore, expenses related to interest play the role of a “shield” against tax obligations. In other words, the tax shield protects part of the taxpayer’s income from being taxed.

Note that tax shields differ from one country to the other. The tax shield benefits are determined by the overall tax rate as well as cash flow for a specific tax year. For those individuals and corporations with an annual tax bill that is high, it is prudent to have investment strategies that are the tax-efficient as it is the backbone of any investment with a high net value.

### How Tax Shield Works

Let’s assume that a firm is considering to either purchase or lease a building. When deciding to take a mortgage to purchase a building for their business, a tax shield will be created as a result. This is because mortgage interest is tax-deductible and the deduction applies to the interest and not on the mortgage payment. If the firm puts a tax shield into consideration when making the mortgage decision, then it will be easier to make  a decision.

### How to Calculate Tax Shield

Calculation of the tax shield follows a simplified formula as shown below:

Tax Shield = Value of Tax Deductible – Expense x Tax Rate

Example

If a business has \$1,000 in mortgage interest and its tax rate is 25%, then the firm will have a tax shield of \$250.

### Examples of Taxable Expenses used as a Tax Shield

Tax Shield for Individual Expenses

Tax shield for an individual is beneficial when you want to buy a home, using a mortgage or a loan. This is because the mortgage’s interest expenses are tax-deductible, making it cheap to pay since it reduces tax liability. Interest loan for students is also another tax shield for an individual, which is also tax-deductible making it cheaper.

Tax Shield for Medical Expenses

If what the taxpayer has paid in medical expenses exceeds what standard deduction covers, then the taxpayer may decide to itemize it in order to get a tax shield which is larger.

Tax Shields for Charitable Giving

Charitable offers also reduce the obligation of paying tax. However, to be able to qualify for this kind of tax shield, as a taxpayer you will have to itemize deductions on your tax returns. Another qualification is that there must be an approved organization receiving the donations.

Tax Shield for Depreciation

This type of tax shield allows recovery of given losses that relate to qualifying property depreciation. Note that the deduction here applies to property that is tangible. Such may include buildings and vehicles. A deduction can also apply to intangible assets like computer software as well as patents. To qualify for this you need to meet the following requirements:

• The depreciation must apply to business or an activity that generate income
• It must have more than one-year lifespan.
• Duration of asset’s ownership and whether it played a part in building capital for improvement.

### Tax Shield Strategies

Both the corporation as well as individuals do benefit from tax shield in one way or the other.  There are two main strategies that companies use to achieve this. They are as follows:

Capital Structure Optimization

Capital structure refers to the mix of equity funding and debt. Given that the interest generated from debt is tax-deductible, it makes debt servicing easier for businesses. Note that there is a significant impact when companies add or remove tax shield, therefore, most business owners will always consider their optimal capital structure.

Accelerated Depreciation Methods

This is where corporations in early years, use a number of depreciation methods to lower taxes. Corporations do this so that they can be able to maximize depreciation expense on their tax filings, given that depreciation expense is tax-deductible. Such depreciation methods may include sum-of-years-digits and double-declining balance.

Since depreciation methods on total expense are the same over an asset’s lifetime, businesses would benefit when they remove the tax expense. Note that tax is a cash expense while depreciation is not. This then means that the businesses will be able to a great value of money.

Benefits of Tax Shield

Tax shield has the following benefits:

• Though it increases expenses, it is, however, reduces taxable income.
• Though it reduces cash on hand, it, on the other hand, places money on investments which in turn results in higher returns which are a desire for any business owner.
• It adds value to a business which is important for that person who wants to sell the business or get loans as well as investors.

### Limitations of Tax Shield

It is true that the tax shield is beneficial to businesses as well as to individual taxpayers. However, there are some risks that emanate when you decide to include a tax shield in your financial plans. The risks may include the following:

• The interest may be too high in that the taxpayer may find himself not able to make the payments.
• Secondly, there is an agreement attached to the debt that an individual or a business is supposed to adhere to. The agreement may include restrictions where a business needs to adhere to, to be able to obtain the debt. Such may include refraining from say, selling of business’ assets.
• Another restriction may be for a business to maintain various levels of ratios such as debt coverage ratio or debt-equity ratio.

The restrictions are basically there to ensure that the business fulfills its financial obligation to the latter. Note that in case the firm is unable to live up to the requirements of an agreement, then it may find itself in financial crisis because of the pressure the firm is under. This makes the debt to be even more expensive for the firm to service hence lowering the value of the business.

Summary

Generally, corporations that don’t consider tax shields in their planning process are not able to make good savings as far as taxable income is concerned. A good way of maximizing tax shields’ tax-savings benefits is by putting into consideration the impact of tax shield when making any of their business financial decisions.

Also, to get maximum savings, they will need to do their tax planning early enough (at the beginning of the year). This is because the rating of some deductions, such as depreciation happens throughout the year. So, if they do it later in the year, they will not be in a position to achieve maximum saving on their taxable income