Tax shield definition
/What is a Tax Shield?
A tax shield is the deliberate use of taxable expenses to offset taxable income. The intent of a tax shield is to defer or eliminate a tax liability. This can lower the effective tax rate of a business or individual in the current tax year, which is especially important when their reported income is quite high.
Tax shield strategies are available for both business and individual tax returns. The effectiveness of these strategies will depend on the tax rate to which a taxpayer is subjected, as well as that party’s initial amount of taxable income. The classic example of a tax shield strategy for an individual is to acquire a home with a mortgage. The interest expense associated with the mortgage is tax deductible, which is then offset against the taxable income of the person, resulting in a significant reduction in his or her tax liability.
Impact of Tax Shield on Valuation
The tax shield strategy can be used to increase the value of a business, since it reduces the tax liability that would otherwise reduce the value of the entity's assets. The effects of the tax shield should be used in all cash flow analyses, since the amount of cash paid in taxes is impacted.
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Examples of Tax Shields
Examples of taxable expenses used as a tax shield are as follows:
Paying out funds for charitable contributions, to charge off the contributions as a taxable expense. The use of contributions as a tax shield is a key tool used by the government to support qualifying nonprofit institutions.
Incurring debt, in order to charge off the related interest expense as a taxable expense. The use of debt as a tax shield is specifically targeted at benefiting homeowners. Home ownership is considered to be beneficial to the stability of society, so providing a tax shield in this area is considered to be good policy.
Incurring medical expenses, in order to charge off the payments as a taxable expense. The use of medical expenses as a tax shield is needed to reduce the tax burden of lower-income taxpayers who incur large medical expenditures.
Acquiring fixed assets, in order to charge accelerated depreciation or amortization (in the case of intangible assets) as a taxable expense. The use of fixed assets as a tax shield encourages businesses to make further investments in their operations, which may make them more competitive and profitable.
How to Calculate a Tax Shield Amount
The value of a tax shield is calculated as the amount of the taxable expense, multiplied by the tax rate. Thus, if the tax rate is 21% and the business has $1,000 of interest expense, the tax shield value of the interest expense is $210.