What Is a Tax Shield?

Key Takeaways

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.

How a Tax Shield Works

A tax shield refers to a legal and allowable method a business or individual could employ to minimize their tax liability to the US government. Properly employed, tax shields are used as part of an overall strategy to minimize taxable income.

As the name suggests, tax shields protect taxpayers from paying taxes on their full income. The Internal Revenue Service (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.

However, tax shields do not only benefit the wealthy. Many middle-class homeowners opt to deduct their mortgage expenses, thus shielding some of their income from taxes. A tax shield may not be suitable 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.

Examples of Tax Shields

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. As a result, the gross income for the business would be reduced by the amount of interest paid on the mortgage, thus, reducing its taxable income.

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.

Another example of a tax shield is the tax deduction for interest expense on student loan debt to lower the person’s taxable income. Some additional 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, which lowers their taxable income and “shields” them from additional taxes.

Standard Tax Deductions

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.

As of the 2022 tax year (the return you’ll file in 2023), the standard deductions are:

For single taxpayers and for those who are married but filing separately returns: $12,950
For heads of households: $19,400
If you’re married and filing jointly, or if you’re a qualifying widow with a dependent: $25,900

As of the 2023 tax year (the return you’ll file in 2024), the standard deductions are:

For single taxpayers and for those who are married but filing separately returns: $13,850
For heads of households: $20,800
If you’re married and filing jointly, or if you’re a qualifying widow with a dependent: $27,700

note

Itemized deductions allow you to deduct the dollar amount of various expenses, such as interest on student loans and mortgages. If your total allowed deductions are higher than your standard deduction, you might be better off itemizing, meaning you wouldn’t take the standard deduction.

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 US 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.

Frequently Asked Questions (FAQs)

How does a tax shield work?

A tax shield refers to tax deductions that an individual or business can take to lower their taxable income. Although tax shields have traditionally been used by wealthy individuals and corporations, middle-class individuals can also benefit from tax shields.