Home Blog Depreciation Tax Shield (Explained: All You Need To Know)

Depreciation Tax Shield (Explained: All You Need To Know)

What is Depreciation Tax Shield?

What is the depreciation tax shield formula?

What’s important to know?

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!

Are you ready?

Let’s get started!

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
Author

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

  • “Depreciation tax shield” refers to the amount of tax saved by deducting depreciation expense from your total taxable income
  • Depreciation is a cost that you allocate to tangible assets over their useful life
  • Depreciation tax shield allows companies reduce their tax liability thereby boosting their net profits
  • You can find depreciation tax shield by determining your depreciation expense and effective tax rate and then multiplying the two
Accelerated depreciation 
Adjusted gross income
Annual depreciation 
Capital budgeting 
Capital structure 
Depreciation method 
Free cash flow 
Interest expenses
Itemized deduction 
Leveraged buyouts 
Net income 
Net present value
Salvage value 
Straight-line depreciation
Tax benefit 
Tax losses
Tax year 
Taxable income 
Tax-deductible 
What is amortization 
What is depreciation
Author
Proportional tax 
Proportional tax vs regressive tax 
Tax systems
Types of taxation
What are payroll deductions
What are tax brackets 
What is a service tax
What is a tax district
What is excise tax 
What is federal income tax
What is FICA
What is flat tax 
What is progressive tax
What is regressive tax 
What is sales tax
What is state income tax
What is tax exemption
What is tax evasion 
What is tax rate
What is tax refund
Author

Editorial Staffhttps://lawyer.zone
Hello Nation! I'm a lawyer and passionate about law. I've practiced law in a boutique law firm, worked in a multi-national organization and as in-house counsel. I've been around the block! On this blog, I provide you with golden nuggets of information about lawyers, attorneys, the law and legal theories. Enjoy!

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