How Tax Shelters Work

An abusive tax shelter reduces the amount of tax a taxpayer owes to the government, but does not provide any means to gain actual money. In practice, it's like hiding the money you owe the IRS in a piggy bank under your bed.

Abusive tax shelters are often "multi-layer transactions" that mask the owner of the money by "flowing" the money through entities specifically set up to receive and store the money, such as International Business Corporations (IBCs) [source: IRS]. When the IRS determines that a taxpayer has participated in an abusive transaction, it assesses penalties and issues bills for unpaid taxes and interest on the unpaid amount.

The IRS has compiled a list of transactions it has deemed to be abusive tax shelters, such as

Let's look at some other abuses in more detail.

Variable Prepaid Forward Contracts

Mr. Jones wants to sell his stock while it's still valuable but does not want to pay taxes on the profits. So he puts the stock in a bank for safekeeping, promising to sell the stock to the bank later. The bank gives him a handsome sum of cash, a significant percentage of the stock's value. But the stock has not yet been officially sold, only pledged. Stock fluctuates in value, so, to prevent a loss on the "pledged" transaction, the bank reinvests the stock elsewhere. The result is that Mr. Jones gets a bunch of cash and doesn't have to pay capital gains taxes.

Offshore Tax Havens

Companies form corporations, banks and trust providers in foreign countries called "tax havens," where taxpayers can hold their money and assets to avoid paying U.S. federal income tax on them. These entities are designed to make it difficult to trace ownership — and therefore tax liability — of the assets. Popular tax havens include Panama, Belize, the Cayman Islands, St. Kitts and Nevis, the British Virgin Islands, and the Isle of Man [source: McCoy].

Inflated Partnership Basis Transactions (Son of Boss)

This complex transaction, popular in the 1990s, involved the formation of partnerships and the artificial inflation of business losses in these partnerships. When the IRS cracked down, it offered a settlement to participants in the scheme. The average participant in Son of Boss paid $1 million to the IRS; one participant paid over $100 million. All told, the IRS restored over $3 billion in unpaid taxes, interest and penalties through this settlement [source: IRS].

Abusive Roth IRA Transactions

Roth IRAs are retirement accounts with contribution caps. You can contribute a certain amount of your earnings within a certain time period. Anything over the cap is subject to an excise tax. To get around this limit, participants create separate businesses whose sole purpose is to make contributions to the IRA. The participants run their money through these businesses to make it look like they're not violating a contribution cap. Income that should be taxed flows tax-free into the IRA.

To learn more about tax shelters, legitimate and abusive, look over the links that follow.