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, which is especially important when their reported income is quite high. Examples of taxable expenses used as a tax shield are:
- Paying out funds for charitable contributions, to charge off the contributions as a taxable expense
- Incurring debt, in order to charge off the related interest expense as a taxable expense
- Incurring medical expenses, in order to charge off the payments as a taxable expense
- Acquiring fixed assets, in order to charge accelerated depreciation as a taxable expense
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 35% and the business has $1,000 of interest expense, the tax shield value of the interest expense is $350.
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.
Tax shield strategies are available for both business and individual tax returns. 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.