Interest Tax Shield What Is It, Formula, Example, Benefits

The term « Tax Shield » refers to the deduction allowed on the taxable income that eventually results in the reduction of taxes owed to the government. The formula for tax shields is very simple, and it is calculated by first adding the different tax-deductible expenses and then multiplying the result by the tax rate. To get the APV, you first calculate the base case value, which is the NPV of the company or project as if it were financed entirely with equity. This is the fundamental value of the business operations without considering any effects of debt financing. The second part of APV accounts for the PV of all financial side effects resulting from the company or project’s debt.

What is the Depreciation Tax Shield?

The first step is to find the interest cost limits and tax rate for the tax year. Some of the fringe benefits you offer to employees increases their total compensation but does not increase your payroll taxes. This can be done with a few of the tax shields below, such as interest and hiring your kids.

How To Calculate?

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. Properly using tax shields as allowed by law should not increase your chances of an audit. However, aggressive tax planning or incorrectly claiming deductions can raise red flags.

• A tax shield will allow a taxpayer to reduce their taxable income or defer their income taxes to a time in the future.
• However, the interest paid on these debts is tax-deductible, thus making it an attractive proposition by creating a shield against a portion of the taxable income.
• Some of the fringe benefits you offer to employees increases their total compensation but does not increase your payroll taxes.
• The value of the interest tax shield is the present value, i.e., PV of all future interest tax shields.
• These deductions reduce a taxpayer’s taxable income for a given year or defer income taxes into future years.
• Therefore, the tax shield can be specifically represented as tax-deductible expenses.

How often should I calculate my tax shield?

This, in turn, makes debt funding much cheaper since interest expenses on debt are tax-deductible. They often do this in one of two ways, either through capital structure optimization or accelerated depreciation methods. Since adding or removing a tax shield can be significant, many companies consider this when exploring an optimal capital structure. An optimal capital structure is a good mix of both debt and equity funding that reduces a company’s cost of capital and increases its market value.

Step 2: Calculate the Present Value (PV) of the Tax Shield

Most of these indirect borrowing costs are non-deductible for tax purposes. Interest tax shield brings financial and strategic advantages to a business and individual. Businesses tax shield can deduct up to a certain limit of interest expense from their profits as an interest tax shield. Any interest expenses over that limit can be carried forward to the next year.

Is Tax Shield the Same As Tax Savings?

The third step is to use the formula mentioned above and calculate the interest tax shield amount. Kelsey’s Killer Key Lime Pies is considering buying new equipment to accelerate the key lime pie manufacturing process. Right now, the store can keep up with local demand, but Kelsey’s social media presence has massively increased the amount of online orders. 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. By using debt, you put less equity into the transaction, and the interest paid on the debt shields the return from taxes.

• Assume that the corporate tax is paid one year in arrear of the periods to which it relates, and the first year’s depreciation allowance would be claimed against the profits of year 1.
• Similarly, local and state taxes paid by a taxpayer are also federal tax-deductible expenses for corporate taxpayers.
• This can be done with a few of the tax shields below, such as interest and hiring your kids.
• Under U.S. GAAP, depreciation reduces the book value of a company’s property, plant, and equipment (PP&E) over its estimated useful life.
• 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%).
• You can also note that the exact difference between the tax liabilities of Company A and Company B is $ 660,000.

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. For more detailed information, consider consulting a tax professional or financial advisor. Additionally, governmental tax websites and reputable financial education resources offer guidance on tax planning and strategies. The applicable tax rate can vary depending on your location and the nature of your business. It’s important to use the current tax rate provided by your local tax authority or consult a tax professional to determine the correct rate.