A tax shield is the reduction in income tax that a taxpayer gets because a deductible expense reduces taxable income. Its size is the deduction multiplied by the marginal tax rate the deduction removes income from, not the deduction itself. A deduction never reaches the tax directly, because taxable income means gross income minus the deductions the Code allows (26 U.S.C. 63(a)). It reaches the base the rate runs on, so the rate decides what the deduction is worth.
The Formula
The size of a shield is one multiplication.
Tax shield = deductible expense x marginal tax rateThe deductible expense is the amount the tax law allows as a deduction for the year, which is not always the cash spent on the item. The marginal tax rate is the rate that applies to the last dollars of taxable income, so it is the rate the deduction takes income out of. For a C corporation that rate is flat. For an individual or a passthrough owner it is set by the bracket the last dollars land in, and a deduction big enough to cross a bracket boundary saves at more than one rate.
The Interest Shield
The general rule is broad: there shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness (26 U.S.C. 163(a)), though for a taxpayer other than a corporation no deduction is allowed for personal interest (26 U.S.C. 163(h)(1)). That is the shield debt financing carries and equity financing does not, and cost of capital is where a firm prices it.
The deduction for business interest has a ceiling. Section 163(j) caps it, and business interest disallowed by the cap is treated as business interest paid or accrued in the succeeding taxable year (26 U.S.C. 163(j)(2)), so the limitation delays part of the shield rather than cancelling it. The cap does not apply at all to a taxpayer, other than a tax shelter barred from using the cash receipts and disbursements method, that meets the gross receipts test of section 448(c) (26 U.S.C. 163(j)(3)). What actually counts as interest for that purpose is set out in interest expense.
The Depreciation Shield
Depreciation is an annual income tax deduction that allows a taxpayer to recover the cost or other basis of certain property over the time the property is used (IRS, Publication 946, How To Depreciate Property). No cash leaves the business in the year it is taken, so this shield is a cash saving sitting on a non-cash charge. For most tangible property the deduction is determined under the Modified Accelerated Cost Recovery System, MACRS (26 U.S.C. 168(a)), covered in MACRS.
Read it as a deferral rather than a permanent reduction. The total deduction an asset produces is capped by its basis, so a faster method moves the shield into earlier years instead of enlarging it (accelerated depreciation), and on a later sale the depreciation already allowed can come back as ordinary income (depreciation recapture).
A Worked Example
Say a corporation runs the same operations under two capital structures, one with no debt and one carrying deductible interest. The amount of the tax imposed on a corporation is 21 percent of taxable income (26 U.S.C. 11(b)), so one flat rate does the work in both columns.
Tax at 21% of taxable income
No debt With debt
Taxable income before interest 500,000 500,000
Interest expense 0 (100,000)
Taxable income 500,000 400,000
Tax 105,000 84,000
Tax saved: 105,000 less 84,000 21,000
Same answer: 100,000 x 0.21 21,000The corporation spent the whole interest amount and got about a fifth of it back in reduced tax. The saving is real, and it is smaller than the deduction that produced it.
What a Tax Shield Is Confused With
A tax shield is not a tax credit. A credit is subtracted from the tax itself, dollar for dollar, while a shield comes off taxable income and is worth only the deduction times the rate, a gap worked through in tax credit.
A tax shield is also not evasion. Claiming a deduction the tax law allows is lawful planning, and where that stops is set out in tax avoidance vs evasion, with the full range of legitimate moves in tax avoidance.
Common Questions
Multiply the deductible amount by the marginal tax rate that applies to the income the deduction removes. Two conditions decide whether that answer holds: the deduction has to be allowed in that year, and there has to be income taxed at that rate for it to work against. Where deductions run past income there is nothing for the rate to remove, and the excess becomes a net operating loss, the excess of the deductions allowed by the chapter over gross income, computed with the modifications the section specifies (26 U.S.C. 172(c)). That loss carries to another taxable year, where a loss arising after 2017 is deductible against no more than 80 percent of taxable income figured without regard to the loss deduction and to sections 199A and 250 (26 U.S.C. 172(a)(2)(B)). It is a tax-return figure, not the same number as the book net loss on a client’s income statement.
An effective tax rate, the average across all of a taxpayer’s income, understates the shield for anyone with income in more than one bracket, because the deduction comes off the top and not off the average.
A tax shield works by shrinking the base the rate is applied to, so it returns part of an expense the taxpayer has already borne. It does not pay for the expense. That is why a deduction is a weak reason on its own to borrow money or buy an asset: the after-tax cost falls by the shield, it does not disappear, and the cash goes out first.
If interest schedules and fixed asset rollforwards are the return work that keeps sliding to the last week, a trial task puts a block of it through Accountably’s review chain before it reaches your own reviewer.
