How Tax Shelters Work

A tax shelter is a legal technique used by taxpayers, whether individuals or businesses, to reduce taxable income. The lower your taxable income, the less you pay in taxes. When you use a legal, legitimate tax shelter, you are avoiding taxes, which should not be confused with evading taxes.

Tax shelters include investments or deposits in accounts that are not heavily taxed, such as retirement accounts. Other shelters include "transactions that lower taxable income," such as charitable donations [source: Investopedia].

The primary difference between a legitimate tax shelter and an abusive tax shelter is the shelter's financial benefit. Legitimate shelters, such as retirement accounts and side businesses, usually generate income. An abusive tax shelter is simply a way to keep money from being taxed.

Many legitimate tax shelters are available to you. These shelters include:

Investing in real estate is a common tax shelter. In addition to the deductions it allows you to make — mortgage loan interest, mortgage insurance and property taxes — a real estate investment can help you grow wealth over time.

Retirement plans, such as pensions, 401(k) and 403(b) plans, and Individual Retirement Accounts (IRAs), have legitimate tax shelter qualities. A worker (and his or her employer) can make pretax contributions to these plans, which consist of a portion of the worker's income before it's assessed for federal withholding. Every plan is different and has its own regulations and contribution caps. The caps are there to keep people from dumping all of their money into a plan to avoid taxation.

When you withdraw money or receive payments from one of these plans, the IRS assesses the tax on the amount withdrawn, but often at a lower rate than it would have taxed the original income.

Putting a portion of one's primary income into a side business is a popular way to shelter oneself from federal income tax. For example, Mr. Boxcar, an insurance salesman with a knack for restoring old model trains, could set up a business to market his repair and restoration skills. Mr. Boxcar will take money from his primary income as an insurance salesman to fund his model train restoration business, which could reduce his taxable income. As long as Mr. Boxcar can prove to the IRS that he is attempting to make a profit with his side business, he can write off many business expenses, including equipment and supply costs.

Municipal bonds are used by smaller governments (state, municipal, county) to fund public works projects, such as taking care of those potholes left after a bad winter. Interest you earn on municipal bonds is not taxed by the IRS.

If your employer provides benefits like health coverage, life insurance and education benefits, you can reduce your taxable income by taking advantage of these opportunities. Typically, you contribute part of your income to the benefit before your tax withholding is calculated.

So now that you know what's legal when it comes to tax shelters, read on to find out about abusive tax shelters.

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.