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What are Interest Tax Shields? Use Interest Expense to Lower Taxes

January 31, 2023

tax shield example

But, Kelsey could also get a loan with a 7% interest rate, 20% down and a seven-year term. C corporations are taxed at the business level, and distributions, or dividends, to owners are taxed at the personal level. This phenomenon is known as double taxation, since the income is taxed twice. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. The concept was originally added to the methodology proposed by Franco Modigliani and Merton Miller for the calculation of the weighted average cost of capital of a corporation.

  • Tax evasion is a form of fraud where you lie about your taxable income, and it’s illegal.
  • Tax shields aren’t always easy to implement and it may not be clear to the average taxpayer how to get started.
  • The reason that he was able to earn additional income is because the cost of debt (i.e. 8% interest rate) is less than the return earned on the investment (i.e. 10%).
  • There is a real-time value of money saved since tax is a cash charge, but depreciation is a non-cash expense.
  • Assume Company X, like any other company, pays taxes and uses debt as one of its primary sources of income.

In addition, the dividend paid on equity is not tax-deductible; the tax shields motivate the company to utilize a higher portion of debt in its capital structure. Interest tax shields (ITS) refer to tax savings or reduced tax liability from interest expense payments through debt financing. The IRS allows you to reduce your taxable income by a specific dollar amount—called a standard deduction. Your standard deduction can help lower your tax liability, especially for those who don’t have tax-deductible expenses, as outlined above. Let’s say a business decides to take on a mortgage loan on a building instead of leasing the space because mortgage interest is tax deductible, thus serving as a tax shield.

Tax Shield Strategies

If you use good tax software, it will automatically prompt you to use the best deductions and strategies. You may have heard that a large charitable donation was “just a tax write-off.” This is partially true, since donating to approved charities can be written off of business taxes. However, keep in mind that, based on the tax shield formula, the tax shield is just the donation multiplied by the tax rate. However, you can adopt certain strategies to increase or decrease your cash flow. One way to increase cash flow is by using tax shields to reduce the net income you report to the IRS and decrease your tax owed.

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The primary purpose of the APV is to bring out the benefits of the tax shields from payments of interest expenses that are tax deductible. In addition, including ITS in valuation creates a higher value for these companies or firms. Taxpayers who have paid more in medical expenses than covered by the standard deduction can choose to itemize in order to gain a larger tax shield. An individual may deduct any amount attributed to medical or dental expenses that exceeds 7.5% of adjusted gross income by filing Schedule A.

effect on capital structure

Depreciation is basically a way to spread out the expense of buying a business asset over the life of that asset. Accelerated depreciation allows you to depreciate more of the asset in the first year or two, and it’s a great example of a tax shield. The two types of accelerated depreciation are Section 179 expenses and bonus depreciation.

  • Given that the interest generated from debt is tax-deductible, it makes debt servicing easier for businesses.
  • 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.
  • Many middle-class homeowners opt to deduct their mortgage expenses, thus shielding some of their income from taxes.

To increase cash flows and to further increase the value of a business, tax shields are used. A Tax Shield is an allowable deduction from taxable income that results in a reduction of taxes owed. Tax shields differ between countries and are based on what deductions are eligible versus ineligible.

What is the U.S Income Tax System Like?

Tax is almost $1,000 less on the year because of the debt shield, and the net income of $44,254 is more than double the cash down payment plus principal. When we increase FE from 0 to 150, in that case, net income decreases from 120 to 30, and the net reduction is 90, and TS remains the same 60. When EBT falls down to zero or negative, in that situation, the firm doesn’t pay anything. Given the decreased taxable income, Company B’s taxes for the current period are approximately $6.5m, which is $840k lower than Company A’s $7.4m in taxes.

The key word here is “reasonable” — if you pay your 15-year-old son $350,000 per year to shred documents on Saturday, the IRS won’t be happy. Another benefit of this strategy is that you won’t have to pay FICA taxes on the child until they turn 18, or FUTA until they turn 21. By using debt, you put less equity into the transaction, and the interest paid on the debt shields the return from taxes. Here are seven tax shields you can realistically take advantage of in your business. Here are a few reasons your business should take advantage of tax shields. For example, if you have depreciation of $100 and a tax rate of 21%, the tax your business is shielded from by the depreciation is $21.

Cash flow for growth

If you are a sole proprietor, consider allocating pre-tax profits to a 401(k) plan or a health savings account. As shown in the completed output above, Company B’s taxes were $840k lower than Company A’s taxes. Here, Company A will carry no debt on its balance sheet (and thus have zero interest expense), whereas Company B will have $4m in interest expense. Taxes play a crucial role in helping governments finance a range of projects, including infrastructure, wars, and public works. Taxpayer funds are still utilized for a number of related reasons today. Consider the shield’s $100,000 yearly worth as an example of an interest expense.

tax shield example

A tax shield is the deliberate use of taxable expenses to offset taxable income. This can lower the effective tax rate of a business or individual, which is especially important when their reported income is quite high. Some common examples include charitable giving, mortgages, and depreciation expenses. Taking tax shields is a legitimate strategy called “tax avoidance.” The opposite is “tax evasion”—deliberately taking illegal deductions, hiding or not reporting income. Failing to pay what you owe can bring on penalties and possible criminal prosecution. Depending on the taxpayer’s total rate and cash flows for the specific year, tax shields differ from nation to nation and have different benefits.

It should be emphasized that the overall cost will remain the same during the asset’s life regardless of the depreciation method employed. As a result, the gain results from using the time value of money and deferring tax payments as long as feasible. A form of tax saving or reduced tax liability from payments of interest expense through the use of debt financing. It should be noted that regardless of what depreciation method is used the total expense will be the same over the life of the asset. Thus, the benefit comes from the time value of money and pushing tax expenses out as far as possible. Since depreciation is a non-cash expense and tax is a cash expense there is a real-time value of money saving.

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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. Because of the tax-deductibility of interest expense, the weighted average cost of capital (WACC) takes into account the tax reduction in its formula. The Interest Tax Shield refers to the tax savings resulting from the tax-deductibility of the interest expense on debt borrowings.

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