What is Depreciation Tax Shield?
What is the depreciation tax shield formula?
What’s important to know?
In this article, I will break down the meaning of Depreciation Tax Shield so you know all there is to know about it!
Keep reading as we have gathered exactly the information that you need!
Let me explain to you what is the depreciation tax shield and how it works!
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Table of Contents
What Is Depreciation Tax Shield
The depreciation tax shield is a phrase used to refer to a technique by which you can reduce your tax liability by deducting depreciation from your taxable income.
Companies operating in asset-intensive industries stand to gain with the depreciation tax shield as they may report a large depreciation value on their assets.
By subtracting depreciation expense from the company’s total taxable earnings, the company will be able to make a significant reduction to the total amount of taxes it will need to pay to the tax authorities.
By the same token, companies that do not have a lot of assets on their balance sheet will not have a lot of depreciation expense to report thereby yielding less benefits from the depreciation tax shield.
Why Depreciation Tax Shield Is Important
Depreciation tax shield is important for companies and individuals as it allows you to use this strategy to legally reduce your overall taxes.
The main benefit of leveraging the depreciation tax shield technique is to reduce your overall taxes, increase your net profit, and have more money to reinvest into the company or pass on to the shareholders.
Depreciation is an accounting method used to allocate costs to tangible physical assets during the course of their useful life.
For example, if you purchase equipment for $100,000 having a useful life of 5 years, you can allocate a $20,000 depreciation cost every year effectively “depreciating” the value of that asset from an accounting perspective.
What’s interesting here is that the $20,000 yearly expense that is allocated to the asset is a non-cash expense (the company did not have to disburse $20,000 for that asset every year).
For this reason, the depreciation tax shield is quite advantageous as you are using a non-cash expense to reduce your overall taxes payable.
Depreciation Tax Shield Formula
How do you calculate depreciation tax shield?
Here is the depreciation tax shield formula that you should use to calculate your tax shield:
Depreciation Tax Shield = Depreciation Expense X Tax Rate
As you can see, with this formula, you can calculate how much you can shield yourself from taxes by leveraging your depreciation expenses.
To see how this formula is used, let’s take the following example where a company has $100,000 in depreciation expense and an effective tax rate of 20%.
You calculate depreciation tax shield by taking $100,000 X 20% = $20,000.
Therefore, the company can achieve a tax shield of $20,000 by leveraging its depreciation expenses.
The higher your depreciation expense, the higher your tax shield.
Conversely, the lower your depreciation expense, the lower your tax shield.
Depreciation Tax Shield Example
Let’s look at an example of depreciation tax shield to better understand the concept.
Imagine that a company has the following financial characteristics:
- Taxable income of $1,000,000
- Total depreciation expense it can report $200,000
- Tax rate of 25%
Without the depreciation tax shield, the company will have to pay $250,000 in taxes as it has a 25% tax rate and $1,000,000 in revenues.
On the other hand, if we take the depreciation tax expense into consideration, we’ll deduct the company’s total earnings by the depreciation and then calculate the taxes on that value.
In this example, we’ll do $1,000,000 less $200,000 (giving us $800,000) on which we calculate 25% taxes (equal to $200,000).
As you can see, the company saves $50,000 in taxes (representing the value of the depreciation multiplied by the tax rate).
Accelerated Depreciation Tax Shield
Another way depreciation tax shield can be used to reduce taxes payable is to use the accelerated depreciation tax shield technique.
With this method, the company or taxpayer will recognize a larger depreciation cost during the first years of an asset’s useful life and recognize less depreciation towards the end of the asset’s useful life.
This way, you can reduce your taxes by a larger amount since you are depreciating your fixed assets or tangible assets at a larger rate.
Depreciation Tax Shield Meaning Takeaways
So there you have it folks!
What is the depreciation tax shield?
How to calculate depreciation tax shield?
In essence, a tax shield is an amount that you are allowed to deduct from your taxable income leading to the reduction of your taxes payable.
Every company will have a different tax shield depending on its effective tax rate.
The depreciation tax shield refers to the notion of deducting the depreciation expense from your taxable income in order to reduce your total taxes payable.
Now that you know what is the depreciation tax shield, how to find depreciation tax shield, and why it’s important, good luck with your tax planning!
Let’s look at a summary of our findings.
Understanding Depreciation Tax Shield
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