Tax ShieldDefined along with Formula & How to Calculate

Written By:
Adiste Mae

What is a Tax Shield?

When a person or a corporation claims allowable deductions on their taxable income such as medical expenses, charitable donations, amortization, mortgage interest and depreciation, the reduction is called a Tax Shield.

Income taxes can be deferred in the coming years or reduce the amount of taxable income for the given year when these deductions are claimed.

Essentially, what the Tax Shield does is lower the owed amount of taxes that is due from a person or a corporation. 

Breaking Down Tax Shield

The formula to compute for the Tax Shield is:

Tax Shield = Deductions x Tax Rate

The term Tax Shield is derived from the ability of the deductions to shield the taxpayer’s income from taxation.

It can vary from country to country and will depend on the tax rate of the taxpayer (higher rate means higher deductions) and what deductibles are considered as eligible or not. 

When it comes to maximizing the tax shield, high income investors – both individuals and companies – prefer to invest in tax efficient investments in order to lower the amount of taxes that they need to pay. 

Example

Suppose a company has annual depreciation of $35,000 and has a tax rate of 12%, the amount of tax savings will be:

$4,200 = ($35,000 x 12%)

Tax Shields as Incentives

In most cases, taking on a debt provides incentive to taxpayers, especially the middle-income earners.

A home mortgage can be used as a tax shield for those who are existing homeowners, as well as those who are interested in purchasing a property because of the tax benefit that it provides. 

Another example of a tax shield used as an incentive is a student loan and works the same as a home mortgage. 

Tax Shields for Medical Expenses

Taxpayers are able to claim deductions on medical and dental expenses that exceed 7.5 % of the adjusted gross income.

This means that those who have paid more on their medical expenses than that of the standard covered deduction will have the option of claiming more tax savings by itemizing. 

Tax Shields for Charitable Giving

Just like medical expenses, money given to charities will provide a lower amount of taxes owed by itemizing the deductions on the taxpayer’s tax return.

However, only charitable donations given to approved organizations will qualify as a deductible.

Depending on the circumstances, the amount of the deductible can go as high as 60% of the adjusted gross income of the taxpayer. 

Tax Shields for Depreciation

When it comes to depreciation as a tax shield, it applies to assets that contribute to the income generation of the company and has an expected useful life of more than 1 year in order to qualify as a deduction.

Both tangible assets such as buildings, vehicles, equipment, etc., and intangible assets such as software, licenses, trademark, etc. can be used as deductions from the taxable income.   

There are also other factors that affect a depreciation’s ability to qualify as a deductible – length of ownership of the asset and whether the asset has been used for capital improvements.