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When you hear about tax shelters you probably first think about some offshore financial haven for the wealthy, like a secret bank account in the Caiman Islands. Although that may be true, you should know that a tax shelter is considered to be a means of minimizing one's tax liability which can be legal or illegal.
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As a matter of fact, the IRS specifies that investments that yield tax benefits are sometimes called “tax shelters.”
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In some cases, Congress has concluded that the loss of revenue is an acceptable side effect of special tax provisions designed to encourage taxpayers to make certain types of investments.
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- In many cases, however, losses from tax shelters produce little or no benefit to society, or the tax benefits are exaggerated beyond those intended. Those cases are called “abusive tax shelters.” An investment that is considered a tax shelter is subject to restrictions, including the requirement that it be disclosed.
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So, what legal tax shelters are there for you?
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| Claiming deductions is a perfectly legal way to reduce the amount of income tax you pay to the IRS. You can easily accomplish this tax shelter by choosing to spend your income on expenses that can lead to a deduction. For instance, if you make a large number of charitable donations during the year with the sole purpose of reducing your income tax bill, the IRS will not challenge your charitable deduction as long as you satisfy all requirements of the deduction. |
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| One of the most widely used tax shelter in the United States are retirement plans, like 401(k) employer sponsored plans and IRAs. These are generally used to both reduce the amount of taxes paid on income as well as to save for future retirement. |
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| If you are a home owner, that is probably your best tax shelter too. As soon as you buy your home, you get deductions for all or part of your mortgage interest, points paid to get the loan, interest on certain home equity loans, and your annual property tax payments. These write-offs can help reduce your tax bill each filing season. |
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| Another example of common tax shelter is the primary residence sale exclusion of up to $250,000 of sale profit for a single taxpayer (twice as much for a married couple filing a joint return) amount which is not taxed. |
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| Regarding more traditional investments, you should consider municipal bonds, which are issued primarily by state or local governments, or state-related organizations. As you probably know, some states don't tax interest on bonds issued by their municipalities. As for the IRS, municipal bond income is not taxed at the federal level. |
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| Another example of legal tax shelters are the flow-through limited partnerships. When investing through a limited partnership, the federal or state governments don’t tax the partnership itself. Instead, the individual investors report their share of any profits or losses and are responsible for declaring the income on their own tax filings. Certain companies, such as mining or oil drilling, often take several years before they can generate positive income, while many of them will go under. This normally deters common investors who demand quick, or at least safe, returns. To encourage the investment, the US government allows the exploration costs of the company to be distributed to shareholders as tax deductions. |
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Other legitimate and legal tax shelters include: employer-sponsored health coverage, employer-sponsored life insurance, employer-funded education, and even the setting up of your own business.
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On the other hand, IRS considers as abusive tax shelters any marketing schemes involving artificial transactions with little or no economic reality. These often make use of unrealistic allocations, inflated appraisals, losses in connection with non-recourse loans, mismatching of income and deductions, financing techniques that do not conform to standard commercial business practices, or mischaracterization of the substance of the transaction. Despite appearances to the contrary, the taxpayer generally risks little.
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| Abusive tax shelters commonly involve package deals designed from the start to generate losses, deductions, or credits that will be far more than present or future investment. Or, they may promise investors from the start that future inflated appraisals will enable them, for example, to reap charitable contribution deductions based on those appraisals. |
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Because there are many abusive tax shelters, it is not possible to list all the factors you should consider in determining whether an offering is an abusive tax shelter. However, you may recognize an abusive tax avoidance transaction if it:
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- Offers inflated tax savings that are disproportionately greater than your actual investment placed at risk. Generally, an abusive tax avoidance transaction generates little or no income or capital appreciation.
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- Is a transaction in which a significant purpose is the avoidance or evasion of federal income taxes. In comparison, a legitimate investment produces income or capital appreciation and involves a risk of loss proportionate to the investment. Additionally, a legitimate investment has a business purpose other than the reduction of taxes.
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- Is often marketed in terms of how much you can reduce your tax liability.
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Among the many provisions designed to combat abusive transactions are new stiffer penalties for acts such as:
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- Taxpayers’ failure to disclose reportable (including listed) transactions;
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- Taxpayers' understatement of tax where the understatement is attributable to a reportable tax avoidance transaction;
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- Taxpayers' failure to report transactions or accounts maintained with a foreign financial entity;
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- Material advisors' failure to comply with new information return requirements or existing regulations requiring that investor lists be maintained and provided to IRS;
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- Tax shelter promoters' making or furnishing false statements in connection with the organization or sale of abusive tax shelters.
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| For tax years beginning after March 18, 2010, a taxpayer may be liable for a 40% penalty for an understatement of their tax liability due to an undisclosed foreign financial asset. An undisclosed foreign financial asset is any asset for which an information return, required to be provided under Internal Revenue Code for any taxable year, is not provided. |
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| If any underpayment of tax on a taxpayer return is due to fraud, a penalty of 75% of the underpayment will be added to their tax. |
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You should always avoid the temptation to falsely inflate deductions or expenses on your returns to underpay what you owe or possibly receive larger refunds. Do not overstate deductions such as charitable contributions and business expenses or improperly claim such credits as the Earned Income Tax Credit or Child Tax Credit. Do not assign income you earn to another taxpayer who is subject to lower tax rates. Equally, setting up a corporation to receive your income and adding a family member to the payroll doesn’t transform your strategy into a legal tax shelter.
It is the Office of Tax Shelter Analysis (OTSA) in the Large Business & International (LB&I) Division that collects and analyzes information about abusive tax shelters and transactions, and coordinates LB&I's tax shelter planning and operation. |
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The IRS will continue to address those using abusive shelters through audits, litigation, published guidance and legislation. The IRS maintains an abusive tax shelter hotline that people can use to provide information (anonymously, if preferred) about abusive tax shelter transactions.
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| For our readers and friends, the best and omnipresent advise in our newsletters is to get help from a trusted tax professional to make sure that you pay all your dues and make good use of all the tax advantages you are legally entitled to. |
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