Interest tax shield means savings taxes through interest cost deductions from profits. It effectively lowers the tax amount that you pay with a debt instrument.
Let us discuss what is a tax interest shield and how to calculate it.
What is Interest Tax Shield?
Interest tax shield refers to savings on taxes by reducing taxable income with interest expenses. It means using tax-deductible interest for lowering the total tax liability.
Interest expense on debt instruments is a tax-deductible expense for individuals and businesses. This is the reason why most businesses look to achieve an optimal balance between debt and equity financing.
An interest tax shield is simply savings by deducting interest costs for profits and ultimately reducing the tax payable amount.
Individuals and businesses need careful planning to make the most of the interest tax shield as the maximum allowable deductions come with limits for them. Therefore, taxpayers cannot simply arrange debt financing for all expenses and start deducting interest costs endlessly.
The interest tax shield applies to qualified interest expenses. For instance, individual taxpayers commonly use student loans and mortgage interest costs as tax-deductible expenses.
How to Calculate Interest Tax Shield?
The first step in calculating the interest tax shield is to know the limit of tax-deductible interest expenses. For instance, you can deduct interest costs of up to $ 2,500 on a student loan per year.
You can use the following formula to calculate the interest tax shield:
Interest Tax Shield = Tax-Deductible Interest Amount × Tax Rate
For instance, if your allowable interest tax cost is $2,000 and the effective tax rate is 25%, then your interest tax shield will be $500.
You can follow these simple steps to calculate the interest tax shield.
The first step is to find the interest cost limits and tax rate for the tax year.
The second step is to calculate the Pre-Tax profit amount. It can be calculated by deducting the cost of goods sold, operating expenses, depreciation, and other admin expenses from the revenue amount.
The third step is to use the formula mentioned above and calculate the interest tax shield amount.
Finally, you can analyze the tax savings coming through the interest tax shield and see whether a fully allowable tax deduction has been achieved for the year.
Let us assume two companies have identical financial figures for a financial year. Company A comes with an annual interest expense of $ 3 million (Allowable) and Company B comes with zero debt.
Both companies have the same profit and sales figures.
- Revenue = $ 100 million
- COGS = $ 45 million
- Operating Expenses = $ 35 million
- Interest Cost = $ 3 million (company A)
- Tax Rate = 22%
- Pre-Tax Profit Company A = $ 17 million
- Pre-Tax Profit Company B = $ 20 million
Tax Company A= $ 17 × 22% = $ 3.74 million
Tax Company B = $20 × 22% = $ 4.4 million
PAT for Company A = $ 13.6 million
PAT for Company B = $ 15.6 million
Interest Tax Shield = Tax-Deductible Interest Amount × Tax Rate
Interest Tax Shield Company A = $ 3 × 22% = $ 660,000
Interest Tax Shield Company B= 0
As we can see, Company A saved $660,000 on taxes due to its interest tax shield. You can also note that the exact difference between the tax liabilities of Company A and Company B is $ 660,000.
Interest Tax Shield for Businesses
The interest tax shield for businesses applies to all types of businesses regardless of their entity structure and size.
Businesses can deduct up to a certain limit of interest expense from their profits as an interest tax shield. Any interest expenses over that limit can be carried forward to the next year.
Businesses can carry forward unclaimed interest tax deductions endlessly. It means they can fully recover their interest costs in the years when they are not paying interest amounts to their lenders.
The IRS guidelines on interest tax expense deductions state that a business can claim a tax-deductible interest cost of up to:
- the taxpayer’s business interest income for the year
- 30% of the taxpayer’s adjusted taxable income (ATI) for the year
- the taxpayer’s floor plan financing interest expense for the year.
Also, new changes to the tax code mean that an entity can deduct interest costs paid to local and overseas lenders. It means that the lender does not have to be in the same jurisdiction as the borrower.
Similarly, local and state taxes paid by a taxpayer are also federal tax-deductible expenses for corporate taxpayers.
Interest Tax Shield for Individuals
Individual taxpayers can also save on interest expenses with qualified interest deductions. However, you cannot deduct all types of interest expenses as individuals.
Qualifying interest costs for individuals usually include first and second mortgages, student loans, and interest paid on business loans (as sole proprietors).
Then, individuals can deduct up to a certain limit. For instance, the interest deduction limit on student loans is $2,500 per year. The interest deduction limit for a mortgage loan is $750,000 for joint filers.
Individuals and corporate clients enjoy other types of tax shields like depreciation, medical expenses, charity expenses, and gifts as well. Each of these tax shields comes with specific rules and is up to certain limits.
Both individual and corporate taxpayers can carry forward the remaining interest costs to the next years.
Special Considerations with Interest Tax Shield
You can take full advantage of the interest tax shield available. However, keep a few key points in mind when planning.
Borrow from Licensed Lenders
The IRS and other regulatory bodies will accept loan qualifications from only licensed and recognized lenders.
Therefore, always apply for a loan with regular lenders like a commercial bank for taking advantage of the interest tax shield.
Specific Spending Conditions
Then, you must spend the loan amount specifically taken for a purpose. For example, if you borrow money for a new machine purchase and spend it on building renovation, it will not qualify.
Although you can use a term loan for any purpose but specific loans like a vehicle mortgage must be spent categorically.
Relevant Interest Costs
Then, include only relevant interest costs in your tax returns as most indirect lending costs may not qualify as tax-deductible expenses.
Finally, keep an eye on interest deduction limits for each type of loan and per-year allocations.
Interest Tax Shield Advantages
Interest tax shield brings financial and strategic advantages to a business and individual.
The most obvious benefit of an interest tax shield is to bring monetary savings for individuals and corporate taxpayers.
As shown in our example above, a business with debt financing will benefit from an interest tax shield and hence will pay a lower tax amount.
Balancing Capital Structure
It is the interest tax shield benefit that lures businesses to debt financing. This is the prime reason why debt financing is cheaper than equity financing.
Therefore, interest tax shield help businesses balance their capital structures.
Increased Borrowing Power
Businesses managing their debt financing well tend to borrow more. They also reap the rewards of paying lower taxes due to the interest tax shield.
Thus, an interest tax shield helps businesses and individuals borrow more and take more financial benefits in the long term.
Business Expansion and Growth
Tax shields and deductions allow business expansion and growth. These incentives help businesses borrow money and adjust a significant portion of that cost against lowered taxes.
In that sense, it contributes to business expansion and growth plans as well as individual financial goals.
Interest Tax Shield Limitations
Although you can take several benefits from the interest tax shield, there are some limitations too.
Limited Deduction Allowance
Interest cost deductions come with maximum limits per tax year. These limits apply to individual and corporate taxpayers with varying conditions.
It means a taxpayer may not be able to fully recover the interest cost of a large loan quickly.
May Not Recover Full Cost
Upper limits on tax deduction mean you may not fully recover the total cost of borrowing. Commercial loans often come with other types of expenses like loan originating fees.
Most of these indirect borrowing costs are non-deductible for tax purposes.
Finally, not all types of loans qualify for interest tax shields. For instance, a personal loan does not qualify for individual taxpayers.