Whenever you run up deductible expenses to reduce your taxes, you're using the tax shield approach. For instance, an individual who makes a big charitable contribution at year's end to claim the related write-off is using a tax shield. Businesses use the depreciation tax shield approach to deduct the cost of assets from their taxes.
To figure out how much you'll save with depreciation, use the tax shield formula: Multiply the amount of depreciation by the tax rate. If you're paying the 21% corporate tax rate and you claim $10,000 in depreciation, the depreciation tax shield is $2,100.
The Tax Shield Approach
Despite its colorful name, the tax shield approach is a mundane one that many taxpayers use: Spend money on deductible business or personal expenses to reduce your taxable income and therefore your tax bill. What's distinctive about a tax shield is that you're using expenses strategically rather than just letting them happen.
For example, suppose you're contemplating buying a $30,000 backhoe next year for your pipe-laying company. You have a lot of income in the current year, so you buy the backhoe in June of this year instead of waiting. That way, you can use six months' worth of depreciation tax benefit to reduce this year's income tax.
Depreciation of Assets
Depreciation is one of the ways you can write off money your business spends on fixed assets such as buildings, computer equipment, furniture and vehicles. Every year of ownership, you get to deduct part of the purchase price as a taxable expense. If you expect the asset to stay usable for five years, you can deduct 20% a year; if it's 20 years, you'd deduct 5% annually.
You also claim depreciation in your bookkeeping, but it may give you a different result than your depreciation tax shield. The role of book depreciation is to show your assets' loss of value over time. Both approaches will eventually zero out the value of your asset.
Tax Rate and Tax Shield
The tax shield formula is simple: multiply your tax rate by the deductible expense to calculate the size of your tax shield. For example, suppose you can depreciate the $30,000 backhoe by $1,500 a year for 20 years. This gives you $750 in depreciation for the first six months of ownership.
If you pay the 21% corporate tax rate, .21 times $750 gives you a $157.50 tax shield. If you're a sole proprietor in the 24% tax bracket, the tax shield rises to $180.
One of the differences between book depreciation and the depreciation tax shield is that tax depreciation is often quicker. Book depreciation is normally on a straight line, taking the same percentage every year. Tax law allows for accelerated depreciation.
Section 179 allows you to write off the entire cost of a fixed asset the year of purchase rather than deducting it over time. Other methods spread out the deduction, but you claim more of it in the early years. Part of the tax shield approach is thinking about which path is best for your business.
If your business startup is struggling and you have a significant tax bill, taking Section 179 or accelerated depreciation is often a good tactic. If you have little taxable income, taking the straight-line approach so you can deduct more depreciation down the road might be a better option.
Tax Shield Drawbacks
The chance to use a tax shield shouldn't be the deciding detail in your business decisions. If you don't need a $5,000 office computer, spending money and claiming depreciation may not be the right tax strategy. The amount you save on taxes will never be as much as you spend on fixed assets, so plan your strategy carefully.