Tax shield is the term used to describe methods for reducing or deferring tax liabilities through legal means. For example, a business might take a charitable contribution deduction or a homeowner might claim a mortgage expense deduction in order to decrease their taxable income.
Tax shields are often used as part of an overall tax-reduction strategy. Employed properly, a tax shield can serve as an invaluable tool for a business or individual to calculate taxable income and minimize payment to the IRS.
Definition and Examples of a Tax Shield
A tax shield refers to a legal and allowable method a business or individual might employ to minimize their tax liability to the U.S. government. Properly employed, tax shields are used as part of an overall strategy to minimize taxable income. Some examples of tax shields include, but are not limited to:
- Medical expenses
- Charitable income
- Mortgage expenses
- Depreciation and amortization
All of these examples enable taxpayers to take deductions on their earnings. This then lowers their taxable income and “shields” them from additional taxes.
How Tax Shields Work
As the name suggests, tax shields protect taxpayers from paying taxes on their full income. The IRS allows businesses and individuals to deduct certain qualified expenses, thereby lowering their taxable income and their ultimate tax liability. This tax-efficient investment method is used particularly by high-net-worth individuals and corporations that face steep tax rates.
Tax shields do not only benefit the wealthy, however. Many middle-class homeowners opt to deduct their mortgage expenses, thus shielding some of their income from taxes. Another example is a business may decide to take on a mortgage of a building rather than lease the space because mortgage interest is deductible, thus serving as a tax shield. Many individuals who carry student loan debt deduct student debt interest expenses too in order to lower their taxable income.
A tax shield is often not recommended for lower-income families. Taxpayers who wish to benefit from tax shields must itemize their expenses, and itemizing is not always in the best interest of the taxpayer. It only benefits you to itemize when the total of all of your deductions exceeds the standard deduction for your filing status. Otherwise, you would be paying taxes on more income than you should be.
As of the 2020 tax year, the standard deduction is $12,400 for single taxpayers and for those who are married but filing separate returns. If you’re married and filing jointly, or if you’re a qualifying widow with a dependent, the amount is $24,800.
The value of a tax shield is calculated as follows:
Tax Shield = Deduction Amount x Tax Rate
Let’s look at the example of an owner of a fleet of trucks whose equipment depreciated over the tax year. Depreciation is a deductible expense, and a portion of the depreciated amount can therefore lessen the owner’s overall tax burden. Assuming depreciation totaled $20,000 and a tax rate of 10%, the truck owner can subtract $2,000 from his total taxable income.
The fleet owner can then subtract the $2,000 from his income, thereby “shielding” his business from taxes on that amount.
Tax Shield vs. Tax Evasion
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.
Tax evaders tend to conceal their income and/or underreport their income on their tax returns. Common methods of tax evasion include deliberately underreporting or omitting income, overstating the number of deductions, keeping two sets of financial records, false accounting entries, and claiming personal expenses as business expenses. Conversely, the legal use of tax shields and other strategies to minimize tax payments is known as tax avoidance.
- A tax shield refers to deductions taxpayers can take to lower their taxable income.
- Examples of tax shields include deductions for charitable contributions, mortgage deductions, medical expenses, and depreciation.
- Tax shields are favored by wealthy individuals and corporations, but middle-class individuals can benefit from tax shields as well.
- Tax shields are legal and should not be confused with illegal failures to pay taxes, known as tax evasion.