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 expensesCharitable incomeMortgage expensesDepreciation 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 separate returns: $12,950For heads of households: $19,400If 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 separate returns: $13,850For heads of households: $20,800If you’re married and filing jointly, or if you’re a qualifying widow with a dependent: $27,700
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 U.S. 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. For example, if you had medical expenses of $15,000 and your income was $50,000, you could deduct the expense, and you would be taxed on only $35,000 of your income.
